Matt Brill highlights challenges and opportunities in U.S. and global fixed income markets in 2022. Among the trends he sees is the potential for major upgrades out of high yield and into investment grade.
The list of concerns facing investors in 2022 is a long one: the Russia/Ukraine situation, the fear of central bank rate hikes, the impact of the “Great Resignation” on labour markets, and the anticipation of the U.S. midterm elections, just to name a few. As I see it, the list of fixed income opportunities is pretty long as well, including the potential for significant upgrades out of high yield into investment grade, a growing supply of Environmental, Social, and Governance (ESG) bonds, and potentially attractive terms for new bond issues.
In the Q&A below, I address the key questions I’m receiving from fixed income investors. Topics include why the interest rate conversation is more complicated than it appears on the surface, and what my favourite investment opportunity is right now.
Last year was a challenging year for U.S. fixed income. What worked and what didn’t in fixed income investing? How might 2022 be different?
Matt Brill: Last year our three key investment themes were reflation, re-opening and re-rating. That meant positioning for higher interest rates and stronger growth as the U.S. economy re-opened. That worked well as the economy grew at a blistering pace last year. We also positioned for credit rating upgrades. These played out to some extent, but we think there are more to come in 2022.
This year, many people think interest rates will drive the U.S. bond market. What are your thoughts on rates and the U.S. bond market in general?
Matt Brill: The one statement I always find interesting is “We know rates are going up.” The fed funds rate is most likely going up this year — the U.S. Federal Reserve (Fed) signaled its intention to start its rate hiking cycle as soon as March. But what about other rates? For example, do we know that the 10-year Treasury yield is going up? The Fed doesn’t control 10-year Treasuries, so that remains to be seen.
We are in the camp that U.S. inflation will start to slow in the second half of 2022, and that we will start to see some supply chain issues ease. But it’s still unclear what will happen from a U.S. labour force standpoint. U.S. labour force participation continues to be on the low end of the historical range, and workers are leaving their jobs in the so-called “Great Resignation.” People are also retiring in greater numbers than ever before, and it feels like there are just not enough workers. 1 If we are short workers and the economy continues to do well, that will likely drive inflation — in the near term. But over the longer term, we believe technological innovation will ultimately drive down wages. We can already see this dynamic at many restaurants — we can order from our tables from our phones, with no wait service required. But technology can’t close every labour gap immediately, and that it is putting upward pressure on inflation in the short term.
The Fed is in a tough bind — inflation has risen more than it expected and has lasted longer. With 2022 U.S. midterm elections on the horizon, Republicans may want to make inflation a political issue and Democrats may worry that inflation could lower voter confidence, especially among lower income voters. While the Fed is independent, this situation leaves the Fed to figure out how it can combat inflation while keeping the economy going. The biggest question for us in 2022 is, can the Fed thread the needle or not? We generally believe it can, but markets may be choppy as it tries. We expect a lot more volatility in 2022 due to this uncertainty.
It’s a big world and global interest rates remain low. What does that mean for global bonds and the U.S. market in particular?
Matt Brill: Globally, there is roughly $9 trillion USD of negative-yielding debt outstanding, with most of that in Europe and Japan.2 The amount has been falling, but that’s still a high number. U.S. rates are still positive relative to Asia and Europe, meaning that high-quality, liquid U.S. fixed income is still potentially attractive to foreign investors. There is also demand from U.S. pension plans and insurance companies that are rebalancing out of equities after their huge run. We think this demand limits how high U.S. interest rates can go.
Another factor driving demand for U.S. fixed income is its high level of liquidity. 3 If investors change their opinions or want to change direction, they can get in or out of their positions fairly easily in the U.S. bond market. This is much harder to do in other parts of the world. U.S. Treasuries are among the most liquid securities, while agency mortgage-backed securities are slightly less liquid. High-quality corporate credit is not as liquid as Treasuries and agency securities, but is still a very liquid, high-quality portion of the U.S. bond market and offers positive yields.
Consequently, we believe the demand for U.S. investment grade corporate bonds will stay relatively strong. Given the challenging interest rate environment abroad, foreign demand for U.S. fixed income may remain particularly strong, which is largely why we believe we will not see major interest rate increases in 2022 or even 2023.
It seems like there are a lot of things to worry about, but the U.S. economy is doing very well. What are your views on corporate fundamentals, such as earnings, debt reduction and credit migration?
Matt Brill: Global and domestic economies are doing very well. Growth will probably moderate this year, but companies are in very good fundamental shape, in our view. In 2018, there was a lot of concern about U.S. BBB-rated companies. The worry was that their high debt levels threatened the U.S. economy and the equity market.
These fears never materialized, however. That’s partly because, in 2019, many BBB companies paid down debt and repaired their balance sheets. In 2020, the world was hit by the pandemic and companies borrowed heavily to survive the storm. But many kept the cash on hand and never actually used it, except for companies like airlines and hotels, whose businesses were struck hard by the pandemic. With earlier concerns in mind, many companies used the opportunity to put their balance sheets in order and, throughout 2021, continued to pay down debt. Currently, the credit metrics of many companies are better than they were pre-pandemic.
Many U.S. high yield companies have also done well. They are viewed as riskier, but in general, their debt levels have also become more manageable as the strong economy has helped many of them grow in size and scale. The rating agencies have been hesitant to upgrade such companies, in light of the events of 2008. But we think we will see significant upgrades this year as the agencies recognize the credit improvement that has taken place. We believe this could represent a large component of the market and could generate positive total returns, even if rates rise. If the Fed makes a policy mistake, that could make it more difficult for high yield companies, but the fact that their balance sheets are in better shape, even if the economy slows somewhat, bodes well for their performance.
It sounds like you expect a year of low volatility for U.S. corporate credit, and that, if there is volatility, investors could benefit from buying that dip, given the strength of the U.S. economy, healthy corporate fundamentals, and potential credit migration.
Matt Brill: Yes, we expect low volatility in U.S. corporate credit bonds relative to interest rates, as interest rates are likely to experience a lot of volatility this year. Longer-term interest rates may provide an attractive buying opportunity later on, but from a credit standpoint, we may not see many chances to take advantage of higher spreads. I think there will be more volatility than last year due to the uncertainty around the Fed, but I am not expecting many defaults and I am expecting many credit upgrades. In general, we favour credit exposure versus interest rate exposure in this type of environment.
How do you anticipate adding value to portfolios in this environment? For example, how do you take advantage of new issuance?
Matt Brill: We expect about $1.4 trillion in new U.S. investment grade debt to be issued this year. This amount is similar to last year, but down 20% to 30% from 2020, which was a very heavy year for borrowing.4 We also expect a smaller amount of new issuance in high yield, since U.S. companies have less debt to refinance, which is positive.
One of the potential advantages of new issues are the concessions they typically offer. Companies often provide incentives to buy newly issued bonds by making them cheaper than their already-outstanding bonds. We try to take advantage of that by being tactical and utilizing our robust research capability to carefully select securities. Additionally, unlike index funds, which generally don’t buy until the end of the month, we can take advantage of a new issue as soon as it’s available, which is an advantage of active investing.
One of the major themes we anticipate this year is the growing supply of ESG-related bonds, particularly green and social bonds. Green bonds finance environmental undertakings while social bonds finance efforts in the social sphere, such as development projects in low-income areas.
Also growing in popularity are sustainability-linked notes (SLN). A company that issues an SLN makes a commitment to meet an ESG target sometime in the future — for example, to reduce its carbon footprint. If the company does not reach its goal, it agrees to pay a higher coupon on the SLN. We expect more of this type of issuance this year.
Another theme likely to be big in 2022 is floating rate investment grade bonds. Even though companies may expect interest rates to rise, we believe market demand for this type of issuance will probably increase and companies will likely respond by meeting it.
Taking an asset allocation perspective, what are you biased toward and biased against, especially as we face rising rates?
Matt Brill: The area we are most concerned about from an asset allocation standpoint is U.S. agency mortgage-backed securities. They are guaranteed by the U.S. government, so their credit quality is not an issue. But the Fed has been the largest buyer of agency mortgages since the pandemic began. As it starts to taper its quantitative easing program and begins quantitative tightening, we think there could be some pressure on agency mortgages.
We like other opportunities within U.S. structured credit, however. We see opportunities in single asset, single borrower deals within commercial mortgage-backed securities, such as those issued by industrial facilities. There may be some opportunities in offices, but, in general, they are still a very tough sector, in our opinion. The U.S. housing market is extremely robust, and non-agency mortgages, which are not backed by Fannie Mae and Freddie Mac and are not bought by the Fed, are attractive, in our view.
Emerging markets (EM) valuations look attractive, and we believe there are opportunities, but 2022 may be challenging. As the Fed tightens monetary policy, which could restrict U.S. growth, what will be the impact overseas? EM spreads are much wider than we have seen in some time, but we are being cautious. There will probably be some winners that have been unfairly punished, for example, by the turmoil in the Chinese property sector, but we believe careful security selection will be essential.
My favourite opportunity right now is the BB portion of U.S. high yield. We believe 2022 is the year of the upgrade out of high yield into investment grade. We think being ahead of that trend is one of the best ways to help dampen volatility and interest rate sensitivity. It involves inherently more credit risk, but not so much, in our view, that a slowing U.S. economy would be too detrimental.
1 Source: U.S. Bureau of Labor Statistics. Data as of December 31, 2021.
2 Source: Bloomberg L.P. Data as of Jan. 31, 2022
3 Source: Bloomberg L.P. Data as of Jan. 31. 2022. Based on the U.S. Government Securities Liquidity Index, which measures prevailing liquidity conditions in the U.S. Treasury market.
4 Source: Invesco estimates. Data as of Jan. 31, 2022