Acing the Year of the Deuces

22 Themes for Bond Investors in 2022

 Hello everyone. I wish each of you a fabulous year ahead, one where you find luck, success, and joy in all aspects of life, striking the perfect balance between home and work, something we are all better at now.

To wit, I spent New Year’s Eve in Switzerland and then trekked onward to Florence, Italy, hoping the grandeur of those places would inspire me to envisage the bond market outlook for 2022. 

With each espresso – and I had quite a few – new ideas emerged. Though each idea is separate, there is a central theme: To achieve the traditional goals of fixed-income investing in the year ahead, an active approach is likely to be the key to success. It won’t be easy — the beta trade is largely over, and “stuff happens” when central banks start taking away their punch bowls after investors have become inebriated by easy money. So hang on for a bumpy ride.

Yet there is smooth air above the turbulence. Climb to it by keeping a long-term orientation and staying mindful of why people invest in bonds: for income and capital preservation. 

Here now are 22 themes and ideas for investing in bonds in 2022 that I hope will give you a smoother ride. (Note that these may not all be appropriate for all investors, so talk to your financial professional about your particular circumstance.)

 Overall strategy

1. Be mindful of trying to market-time the diversification benefits of bonds: When yields rise, it becomes tempting to shed bonds, but I strongly urge seriously contemplating that temptation and maintaining a portfolio context. Market timing the potential diversification benefits of bonds is akin to the mindset of someone who decides they can time their purchase of a warranty or anything else that may provide protection when things go wrong.

2. Beat the forwards: This is a big one. Nearly all bond market strategy attempts to achieve a rate of return that beats implied forward rates. The bond market is priced for higher yields in the years ahead. The question is, is it enough? I believe the market is priced for yields to be a bit too low, and so I favor an underweight to portfolio duration – or market exposure to longer-dated interest rates – though modestly. Opinions differ and there may be reasons to overweight, which I discuss next.

3. Keep duration decisions in a portfolio context: Bonds can serve as a diversifier for the riskier components of an investment portfolio, so it is often best to keep duration decisions in a portfolio context, calibrating the proper dosage to the amount of equity and credit beta (or market exposure) within the portfolio. This tends to be a better approach than point forecasts. Focus on prudence.

4. Remember that tough love from the Fed can be a good thing: Like 2021, 1994 was not a great year for bonds from a return perspective, though bonds kept their diversifying benefits with strong returns in traditional 60/40 stock-bond models. In 2022, the Federal Reserve is expected to show “tough love,” hiking rates and shrinking its balance sheet. This ultimately can be a good thing for the bond market if it results in slower economic growth and a lower inflation rate.

5. Watch the 5-year/5-year (part I): There are two 5y5y gauges to watch for signals about valuations and expectations. One is the Fed’s 5y5y breakeven index, which gauges inflation expectations over the five-year period starting in five years. Recently hovering around 2.34% (source: Bloomberg), levels closer to 2.75-3% may garner the Fed’s wrath, affecting many markets. 

6. Watch the 5-year/5-year (part II): The second such gauge measures where market participants expect the 5-year Treasury to be in five years. It is a good proxy for where market participants expect the Fed’s policy rate to be. Currently at 2.13% (Source: Bloomberg), the 5y5y signals a relatively benign outcome that many markets can live with. To the extent the 5y5y moves higher, investors could become unnerved. Keep in mind that this gauge was often around 3% in the 2010s.

Yield levels

7. Amid change, expect the bond market to maintain “New Neutral” characteristics: Bond investors learned in the 2010s that the neutral level for policy rates had fallen, with the Fed and other central banks struggling to increase their policy rates. In 2022, central banks will likely encounter similar issues, constraining bond yields. Potent long-term influences are at play here, including demographics, slow credit creation, and a mismatch between saving and investment, which I discuss next.

8. Watch the saving glut: Excess saving finds its way into the bond market, suppressing yields. The gargantuan money printing of recent years ensures that the saving glut will remain for some time. Yet, change is in the air. Efforts to decarbonize and invest in both human and physical infrastructure may absorb excess saving, upending a potent influence on yields, albeit quite slowly.

9. Do the math when forecasting bond yields: Three factors influence bond yields the most: expected real short rates, expected inflation, and a term premium. If yields climb further in 2022, investors might forget the math and trade on emotion, causing an overshoot. Rise above that by considering these estimates I have devised for the U.S. 10-year: flat to -0.5% for the Fed’s real policy rate; expected inflation of about 2.5%; and zero for the term premium – or the extra yield on longer-term bonds compared with shorter-term ones –which has been negative for most of the past five years. That’s a fair value of about 2%. Of the three, the term premium likely has the most potential to increase, but for it to persist will require a big change in underlying fundamentals. So, if yields rise, stay calm and do the math.

10. Consider laddering: With this strategy, risks from rising yields can be mitigated, and it can help an investor avoid the temptation to time the bond market. With a laddering approach, maturing bonds are reinvested in the prevailing interest-rate climate, smoothing the portfolio impact of interest-rate volatility.

11. Consider high-coupon bonds: When yields rise, high-coupon bonds may be superior to low-coupon bondsbecause their duration level tends to be lower (for bonds of equal maturity and credit quality). Second, the income from high-coupon bonds can be reinvested at higher yields. Of course, if yields fall the opposite would be the case.

12. Shout out for callable bonds: For bond investors worried about rising yields, callable bonds may be attractive. As yields rise, the probability of a callable bond being called by its issuer declines, boosting the attractiveness. The opposite is the case when yields fall.

Yield curve and the business cycle

13. Watch the yield curve: A legendary tool, the yield curve is the closest thing that the bond market has to a crystal ball. It can help an investor more deftly select bonds of varying maturities, sectors, and credit quality for the different phases of an economic cycle. The current cycle is moving at warp speed, so keep an eye on the curve, focusing on the spread between 3-month T-bills and 10-year Treasury notes. Some studies -- including one by Arturo Estrella and Frederic Mishkin, formerly of the Federal Reserve -- suggest a spread of -50 basis points (or -0.5 percentage point) signals around a 50% chance of recession one year out.

Corporate bonds and credit more broadly

14. Be mindful of a structural problem in the bond market: Liquidity is a major problem in the bond market. Investors can’t readily decide to sell a bond at zero cost. The root of the problem is a breakdown in the principal-agent model, which began after the 2008 global financial crisis. Intermediaries have become either unwilling or unable to hold bonds in inventory. Here’s evidence: In 2007, primary dealers (the intermediaries) held $300 billion of corporate bonds, according to data from the New York Fed. Today that figure is less than $10 billion. This is astounding, especially given that the corporate bond market has more than doubled in size since 2007. Therefore, when the credit cycle turns, stay mindful that it could end chaotically, just as it did in 2008 and 2020. Rather than get trapped by the broken intermediary model, consider maintaining ample liquidity to take advantage of future volatility. 

15. Broaden your credit exposure: The beta trade was short and swift, with credit markets recovering quickly and strongly after the onset of the pandemic. Now it is time for more careful positioning in credit, selecting bonds from the global opportunity set. Credit exposures may include non-agency mortgages and a number of asset-backed securities having resilient cash flow and or seniority in the capital structure. The bond market is vast, with more than $110 trillion of securities, so shop every aisle to find appropriate bonds for your appetite.

16. Watch the “B”s: The biggest rating cohort of the corporate bond market is BBB, a segment that offers a yield premium over more highly rated bonds, in part because there are so many of them and also because they are on the cusp of a junk rating. Yet, historical default data indicate that more than 99.5% of BBB bonds reached maturity (Source: Moody’s data). It therefore tends to be an attractive cohort. Nevertheless, “B” cautious, because a turn in the credit cycle is apt to result in plenty of selling of BBB rated bonds.

17. Consider private markets: Public markets are relatively easy to access, making them prone to richening. In contrast, private markets are not, making it possible for investors able to access the opportunity to extract the excess complexity and liquidity premiums embedded in private assets in both credit and equities, albeit in exchange for the enhanced risks that come with investing in private assets.

Municipal bonds

18. Watch the ratio between munis and Treasuries: Retail investors dominate the municipal bond market,and when those investors express a view on bond yields, it affects the muni market disproportionately. That’s one reason the ratio between yields on 10-year AAA rated munis and U.S. Treasuries is extraordinarily low, at around 67% (Source: Bloomberg). If yields rise, expect that ratio to climb and create better value in the tax-exempt market.

Cash management

19. Prepare for better returns on cash: Often overlooked, particularly because of today’s de minimis money market yields, cash investments can be an integral part of an overall investment strategy. Bolstering cash amid richly valued markets may enable investors to take advantage of volatility, boosting alpha generation over time. Money market yields are set to move higher, which will make the waiting a little easier. Consider stepping slightly outside of the so-called 2a-7 world – where regulations constrain maturity length to 60 days and limit investments in credit – toward more flexible mandates that nonetheless place emphasis on capital preservation.

Mortgage-backed securities

20. Consider active management of your MBS exposures: Interest-rate volatility is the bane of the mortgage-backed securities (MBS) investor, since it creates uncertainty about future mortgage prepayment rates. In volatile climates such as the one 2022 might bring, careful attention need be paid to coupon selection and convexity risks, the sort that I hand off to specialists in such times. By convexity risk, I mean the risk that yields on MBS will move at an increasing and faster pace than those of Treasury yields due to a decline in prepayments and the duration extensions they result in. A halt to the Fed’s bond-buying program increases the urgency to be thoughtful and strategic about MBS investing in 2022, with an overreaction both a risk and potential opportunity. 

Emerging markets

21. Pick up the pieces rather than catch falling knives in EM: The emerging markets met challenges in 2021, with local bond yields climbing in many nations, partly due to rising U.S. yields. Some local EM bonds now have a significant real-yield premium over developed market to go alongside enticingly poor sentiment, which is intriguing, especially if investments in those assets are kept in a portfolio context as potential diversifiers.

Signals from equities

22. Keep an eye on equity multiples: When the Fed tightens policy, it tends to result in lower earnings multiples. To the extent that multiples fall faster than market participants expect, there could be knock-oneffects in other markets, because equity risk is among the greatest risks that investors face, so keep an eye on those risk assessments. 

The above is meant as a foundation to keep our conversation going in 2022. I look forward to connecting with you again soon – with in-depth views such as this one as well as short, pithy ones that respond to incoming data, information, and changes in valuation – as we all attempt to be good stewards of the capital markets on behalf of those that put their trust in us.

 Tony Crescenzi is a market strategist and portfolio manager at PIMCO and is also a member of the firm’s investment committee. Click here for more about Tony. 

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