Preparation of bond allocations for the coming year
Managing bond strategies in a low interest rate environment has been a challenge for years. Recently, shifting US Federal Reserve (Fed) policy, changing economic circumstances, and inflationary dynamics stemming from the pandemic have exacerbated the challenge for many passive fixed income investors. Just as 2021 has provided excellent tactical opportunities for active managers to outperform passive strategies, we believe the changes over the coming year present new challenges and opportunities.
Inflationary concerns were at the fore, as pent-up demand and excess liquidity responded to supply-side constraints and input cost pressures. The Fed held firm on the dot plot, which called for accommodative monetary policy until 2023. After debating the transient nature of post-Covid-19 inflation for more than a year, the Fed has finally decided that some of the inflationary pressures are stronger and likely to persist longer than expected. It is still not clear whether they waited too long or not. In the current environment, we expect a rapid change from previous accommodative policies, which may require further consideration of fixed income positioning through 2022.
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In addition to keeping its target rate close to zero, the Fed has continued a healthy expansion of its balance sheet to support bond prices across the yield curve. During this period, a dumbbell strategy using Inflation-Protected Treasury Securities (TIPS) further down the yield curve and nominal short-term bonds performed well. With the expectation of an imminent decline in bond purchases and faster rate hikes, as recently reported by the Fed, bond positioning for 2022 will be more of a challenge for passive investors.
To get a clearer idea of the impact of a Fed tapering, we can look at the spread between the nominal 10-year Treasury yield and the Consumer Price Index (CPI). Although bond investors are not paid as before for the risk of inflation, the current nominal spread of the 10-year Treasury over the CPI stands out. In November, the US Consumer Price Index (CPI) hit a nearly 40-year high while the 10-year Treasury yield remains well below 3%. This should be a concern for bond investors if inflationary pressures persist longer and are higher than the breakeven TIPS spreads currently suggest.
A decrease in asset purchases by the Fed could prove to be a double-edged sword for the bond market in 2022. On the one hand, any decline in bond purchases should have an impact on demand supporting prices. On the other hand, there remains the question of the effectiveness of the Fed’s plans regarding the pace of tapering. As it stands, we believe that a slow pace of reduction will do little to fight inflation. In addition, some inflationary pressures, such as wage rates and rents, tend to be persistent.
If inflation persists as expected, the Fed will step up the pace of rate hikes, barring further bearish surprises to the economic landscape. This would send a message to the long end of the curve while raising short-term rates and eventually flattening the rate curve. We are already seeing a glimpse of the flattening of the yield curve purely because of market expectations.
We believe there is little point in taking duration over the past 10 years, as the 10 to 30 year area of the yield curve flattens and maybe even reverses. The shorter part of the bond market becomes more difficult as we move into 2022 with potential Fed rate hikes accelerating the rise in short-term rates impacting bonds in this area of the yield curve. .
While it might seem fairly intuitive to own TIPS in an inflationary environment, we also need to understand that the bond market is a forward-looking mechanism that already takes into account a change in the dynamics of inflation and the politics of the market. Fed. Long-lived TIPS, which have performed well over the past year, should become less attractive as the Fed takes the fight against inflation seriously. While there are still benefits to be gained from further CPI adjustments, the market tends to incorporate these changes long before they become a reality by weakening demand. Currently, we don’t see much value in the different areas of spreads, which creates a conundrum as the yield advantage over US Treasuries helps alleviate some of the downsides of rising rates.
In this environment, a shorter duration than the general fixed income market makes sense. The highest value on the yield curve is currently in the 3-5 year area with 3 year maturities offering the most value when considering risk as measured by duration in our view. With a potential policy change, we believe that keeping the overall duration in the 5 year range is most attractive with an allocation to short term floating rate bonds. We still favor TIPS at this point; however, we have reduced exposure and shortened the duration of our TIPS position. When it comes to sector allocations, there isn’t much value when you consider where the options’ adjusted deviations lie from their historical averages. High yield bonds clearly stand out here with spreads well below their 5-year averages as we move into an environment vulnerable to Fed policy errors. In this scenario, we favor bond sectors that have better relative value, such as investment grade securitized bonds and senior loans, which are higher in the capital structure than high yield and have floating rate coupons.
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