Fixed Income Update: Fourth Quarter 2021

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KEY POINTS

• Inflation, central bank policy and the yield curve remain prominent in bond investors’ minds despite the persistence of COVID-19.
• Global central banks have turned markedly more hawkish as they prepare to fight “sticky” inflation.

Long-Term View

• Inflation remains elevated. However, investors expect inflation will eventually return to pre-pandemic levels.

• Despite intra-quarter headwinds and the pandemic persisting longer than many had anticipated, the U.S. economy continued to show signs of recovery. Employment data, as measured by nonfarm payrolls and ADP’s
  National Employment Report, was positive, although reported figures did not consistently beat consensus estimates. The unemployment rate fell to 3.9% while labor force participation ticked up to 61.9%.
• Inflation remained at the forefront for financial pundits and politicians alike. Headline inflation — +0.8% for November versus consensus of + 0.7% — delivered its highest rate since 1982. Year-over-year inflation rose to 6.8%.
  
  

• After remaining accommodative throughout the year, the Fed reeled in more of its pandemic stimulus by announcing a reduction in its asset purchase program. Following the initial announcement, the Federal Open Market Committee (FOMC) announced further acceleration, aiming to end the program by March 2022. Additionally, the committee dropped the word “transitory” from its communications about inflation.
• Despite a personal trading scandal affecting three Fed staffers, Jerome Powell was renominated as the Fed’s chair and Lael Brainard was elevated to vice chair. While Powell and Brainard share similar policy views, the FOMC turned much more hawkish, signaling that their approach to interest rates may change soon. The median FOMC member projection, according to the most recent “dot plot,” is for three rate hikes in 2022.

• As inflation ran hot around the globe, central banks began pivoting toward reducing monetary accommodation. The Bank of Canada ended its quantitative easing program by November. Both the Bank of England and the Fed turned more hawkish as they grappled with high inflation and potential pandemic-related lockdowns.
• The Bank of England and Reserve Bank of New Zealand raised rates by 15 and 25 basis points, respectively. Several emerging market central banks also raised rates. Central banks are signaling that they are concerned about inflation, so the days of ultra-accommodation are may have passed.

• Option adjusted spreads (OAS) for bonds with 1-3 years maturity widened 10 basis points over the quarter and ended the year at 42 basis points. The widening can be attributed to interest rate volatility and poor liquidity.
• However, demand for front end corporate paper remained strong.
  Following the Fed’s pivot, Treasury and agency paper with maturities beyond March 2022 sold off. Shorter paper continued to trade on top of or through the Fed reverse repo facility floor of 5 basis points.

Performance:

• Contributors: duration, trading
• Detractors: curve, asset allocation

Current Positioning:

Portfolios are positioned neutral-to-long duration relative to their benchmark. Their cash benchmark means purchasing corporate or Treasury bonds makes the portfolios long duration.

• The Treasury market experienced increased volatility over the quarter in anticipation of upcoming changes in monetary policy. Investors are expecting the Federal Reserve to hike rates sooner rather than later, causing a strong curve flattener. The 10-year Treasury yield moved as high as 170 basis points and as low as 134 basis points intra-quarter.
• TIPS breakevens were volatile and moved higher as the breakeven curve steepened. The move was most pronounced in the front end of the curve, due to its sensitivity to Fed policy.

Performance

• Contributors: inflation carry, longer dated rates
• Detractor: duration in the belly of the curve

Current Positioning:

Portfolios are positioned neutral-to-long duration relative to their benchmarks because we believe the market is incorrectly pricing in inflation and the Fed tightening cycle.

• High grade companies significantly slowed their bond issuance, due to the holidays and interest rate volatility. December was the lightest issuance month of the year, with roughly $62 billion of bonds issued. Demand for corporates remained strong, with the average deal oversubscribed by more than two-and-a-half times.
• Higher credit quality corporate bonds performed better over the quarter. Returns: AAA (+1.12%), AA (+0.59%), A (+0.14%), BBB (+0.23%).

Performance

• Contributors: curve, asset allocation
• Detractor: security selection

Current Positioning:

Portfolios are positioned neutral-to-long duration relative to their benchmarks, while maintaining a moderate overweight to corporate bonds.

• High yield credit spreads tightened 6 basis points over the quarter to close at 282 basis points, after widening to 336 basis points in November. The transportation sector tightened (-33 basis points) the most while technology experienced the most spread widening (+27 basis points). B rated bonds (+0.84%) were the best performing bonds within high yield, followed by BB (+0.75%) and CCC (+0.54).
• While 2021 was a record issuance year for high yield companies, fourth quarter issuance was the lowest of the year. The index finished up 5.28% for the year and up 0.71% for the quarter.

Performance

• Contributors: security selection
• Detractors: curve, duration

Current Positioning:

Portfolios are positioned to manage the impact of market and sector volatility, while focusing on income generation and downside risk protection. We will remain positioned in the mid-range of the credit risk spectrum.

• Yields rose on shorter maturities and fell on maturities 10 years and longer as the yield curve flattened, helping relative performance versus most indices.
• Longer mandates generally outperformed their shorter counterparts.

Performance

• Contributor: duration
• Detractor: yield curve

Current Positioning: Interest rate risk should typically be neutral to start the year, but trend defensive into February and March. Higher quality credits are attractive, as BBB and A rated spreads remain tighter than pre-pandemic levels

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