Inflation was the dominant theme in financial markets in 2021 and in the manager they believe that it is likely that it will be a important factor for returns in 2022.
In his annual review of the investment prospects Out of 46 of the world’s largest investment banks and asset managers, Bloomberg News found that the word ‘inflation’ appeared 224 times, while there were only 36 results for the term ‘COVID’. The study concluded that “price increases loom over virtually all forecast scenarios” by the experts in 2022.
The debate about what “more or less transitory” What inflation would be like as world economies came out of Covid lockdowns back in 2020 dominated the markets in 2021, but at the end of last year the data seemed to have put an end to the discussion. In November, the US consumer price index (CPI) reached 6.8%, its seventh consecutive record above 5%, while the British CPI hit a 10-year high of 5.1% and the basket of the German purchase became more expensive to 5.2%: its highest record since 1992.
The famous maxim that “inflation is bad for fixed income”, In part, it is based on the fact that inflation erodes the value of the coupons and the principal that holders of fixed rate bonds will receive in the future. From a portfolio management point of view, the main challenge of rising inflation is that it tends to cause interest rates to rise, which can have implications of all kinds, both for US Treasury bonds and for those of high yield and those of emerging markets.
It is undoubtedly true that inflation is bad for some bonds. But for active fixed income fund managers, who have a global bond market of more than $120 trillion1 to choose from, there is a collection of tactics that we believe can help mitigate the impact of inflation. Right now we see a number of opportunities that we believe can help investors thrive in the current circumstances.
1. Keep duration low
In fixed income, the main concern around inflation is that it tends to lead to losses in rate markets, such as US Treasuries, which in turn can lead to losses in credit products when the spread it is too narrow to absorb rate weakness.
Investors got a souvenir dose of this risk in the first week of 2022, when the 10-year UST yield hit a nine-month high of 1.73%, just minutes after the December Fed meeting suggested that rate hikes could come sooner than markets had priced in. In the manager’s opinion, this story has only just begun; With US unemployment falling to 3.9% in December and inflation at a maximum not seen for 40 years, the conditions for the Fed to tighten its monetary policy have been more than fulfilled and the central bank is moving along a catwalk very narrow.
Therefore, Vontobel’s first strategy to beat inflation with fixed income is to keep duration low. This can be achieved, in part, through portfolio construction – avoiding long-duration sovereign debt altogether and holding short-duration rates exclusively for liquidity purposes, for example – but, given our belief in rising yield curves, rates, it seems to us that hedging rate exposure with an interest rate swap, where applicable, makes quite a bit of sense, given its relatively low cost.
Vontobel’s preferred hedge of yield curve risk would be GBP given low carry costs and our forecast is for the 10y Gilt yield to rise to 1.40% before the end. of year. The euro curve would be a good alternative, but not as attractive, in our opinion.
2. Look at floating bonuses
For long-only fixed income investors, there is no such thing as a perfect hedge against inflation, as it is impossible to completely eliminate duration risk from a portfolio (that is, as long as you want to hold assets that could yield returns). . Inflation-linked government bonds, such as US TIPS (Treasury Inflation Protected Securities), are not as effective as one might think, and while tactical interest rate swaps, mentioned above, can offer some protection against rising yield curves, should be carefully sized, as they could quickly become the dominant position in a portfolio.
So his second strategy is to look at floating bonds, which add no interest rate risk to the portfolio because their coupons grow in proportion to each rise in base rates. Leveraged loans should find good support here, as should the entire European asset-backed securities (ABS) market.
For investors looking to tap into these two sectors, European Collateralized Loan Obligations (CLOs) are one of our top picks for 2022, with the best results likely to be found at the lower end of the credit rating spectrum. At Vonotbel they believe that BB-rated European CLOs could return around 7% this year, thanks mainly to the high carry they offer.
3. Focus on yield and roll-down
The third strategy is to focus on the yield and the roll-down. Yield may be one of Vontobel’s most effective weapons against inflation, as it helps cushion a portfolio against the corrosive impact of rising rates, while roll-down – the natural narrowing of the spread that occurs at as bonds approach maturity – can significantly reduce a portfolio’s duration risk.
It is well documented that the relentless rally in risk assets in general since the worst of the COVID-19 crisis some 18 months ago has made returns in many fixed income sectors look expensive relative to their historical prices but, with credit fundamentals looking extremely strong, they seem justified to us and we still see pockets of value to focus on.
Subordinated bank debt, and more specifically Additional Tier 1 (AT1) debt issued by European banks, is another of our main bets for 2022. Banks are traditionally more immune to inflation than other sectors and tend to benefit from the rise of interest rates. The sector also demonstrated its resilience during the 2020 crisis, when banks maintained and even increased their bank capital despite difficult economic conditions.
There are currently many well-capitalized institutions with AT1 bonds offering what we believe to be fairly healthy returns. For example, if it were to go public right now, a five-year, BBB-rated AT1 deal from an A-rated bank could have a yield of close to 5%, according to our projections.
They also believe that hard currency emerging market corporate bonds have the potential to significantly outperform this year as growth and earnings are expected to catch up with those in developed markets. However, go with the caveat that this opportunity could quickly evaporate if the Fed embarks on a more aggressive monetary policy tightening cycle than it has been hinting at; in our annual outlook we said this was not a first quarter trade, and the market’s reaction to the Fed meeting may have already validated that view. However, with the Emerging Markets High Yield Fixed Income Index at 7.4%2, they think there should be opportunities here for investors who are patient and get the timing right.
As for the roll-down, it is a defensive tactic that Vontobel believes is best used when markets are well priced, typically mid to late in the cycle. Early in an economic cycle, when most assets look cheap relative to historical averages, we would typically focus on longer-dated bonds to earn higher returns for longer. However, credit now seems to be in the middle of the cycle and in the last 18 months credit curves have flattened in the long end.
As we approach the next leg of this fast-moving cycle, we see the short leg rising as investors price in rate hikes, and so we expect bonds with shorter durations (particularly those with are in the three to five year range) offer investors the maximum in terms of roll-down gains. It is also important to note that concentrating on the roll-down in the short part of the curve is only really effective if you buy bonds with enough spread to absorb the expected rate hikes.