Skip to content

Fixed Income Update: Fourth Quarter 2021

Bond investors are focusing on inflation, central bank policy and the yield curve. Central banks are turning hawkish.

 

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.

q4 2021 fixed income chart 1

Long-Term View

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

ECONOMY

  • 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%.

q4 2021 fixed income chart 2

FEDERAL RESERVE

  • 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.

q4 2021 fixed income chart 3

GLOBAL CENTRAL BANKS

  • 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.

q4 2021 fixed income chart 4

ULTRA-SHORT/CASH

  • 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.

q4 2021 fixed income chart 5

TREASURYS AND TREASURY INFLATION-PROTECTED SECURITIES (TIPS)

  • 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.

q4 2021 fixed income chart 6

INVESTMENT-GRADE BONDS

  • 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.

q4 2021 fixed income chart 7

HIGH YIELD RETURNS

  • 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.

q4 2021 fixed income chart 8

MUNICIPAL BONDS

  • 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

q4 2021 fixed income chart 9

IMPORTANT INFORMATION. The information contained herein is intended for use with current or prospective clients of Northern Trust Investments, Inc. The information is not intended for distribution or use by any person in any jurisdiction contrary to local law or regulation. Northern Trust and its affiliates may have positions in and may effect transactions in the markets, contracts and related investments different than described in this information. This information is obtained from sources believed to be reliable, and its accuracy and completeness are not guaranteed. Information does not constitute a recommendation of any investment strategy, is not intended as investment advice and does not take into account all the circumstances of each investor.

This report is provided for informational purposes only and is not intended to be, and should not be construed as, an offer, solicitation or recommendation with respect to any transaction and should not be treated as legal advice, investment advice or tax advice. Recipients should not rely upon this information as a substitute for obtaining specific legal or tax advice from their own professional legal or tax advisors. References to specific securities and their issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. Indices and trademarks are the property of their respective owners. Information is subject to change based on market or other conditions.

Forward-looking statements and assumptions are Northern Trust’s current estimates or expectations of future events or future results based upon proprietary research and should not be construed as an estimate or promise of results that a portfolio may achieve. Actual results could differ materially from the results indicated by this information.

Past performance is no guarantee of future results. Performance returns and the principal value of an investment will fluctuate. Performance returns contained herein are subject to revision by Northern Trust. Comparative indices shown are provided as an indication of the performance of a particular segment of the capital markets and/or alternative strategies in general. Index performance returns do not reflect any management fees, transaction costs or expenses. It is not possible to invest directly in any index. Gross performance returns contained herein include reinvestment of dividends and other earnings, transaction costs, and all fees and expenses other than investment management fees, unless indicated otherwise.

Northern Trust Asset Management is composed of Northern Trust Investments, Inc., Northern Trust Global Investments Limited, Northern Trust Fund Managers (Ireland) Limited, Northern Trust Global Investments Japan, K.K., NT Global Advisors, Inc., 50 South Capital Advisors, LLC, and personnel of The Northern Trust Company of Hong Kong Limited and The Northern Trust Company.

© 2022 Northern Trust Corporation. Head Office: 50 South La Salle Street, Chicago, Illinois 60603 U.S.A.