With interest rate hikes on the horizon, what lies in store for the fixed income markets? And how should advisors position their clients’ portfolios accordingly?
To find out, we turned to the Franco Ditri, investment specialist in T. Rowe Price’s fixed income division. In his role, Ditri covers the full range of fixed income strategies, working closely with clients, consultants, and prospects in the intermediary channel in North America. He has also served in roles at Invesco, Brandywine Global Investment Management, Susquehanna International Group, and others.
Lara Crigger, managing editor, ETF Trends & ETF Database: T. Rowe Price just published its 2022 market outlook. In it, you address a question that’s top of mind for many of our readers: “Where can I find income?” So let me kick it to you, Franco. Where the heck can advisors find income in 2022?
Franco Ditri, investment specialist, T. Rowe Price’s Fixed Income Division: Taking a look at the fixed income markets, everyone knows that spreads are incredibly tight. They’re at the tightest levels they’ve been in certain sectors in the last 20 years. So where can we find income, especially in this type of market? At this point, we tend to find income in shorter-duration fixed income. We tend to favor certain areas, such as floating-rate bonds with very short duration, typically less than half a year, or the 1-3 year space. In fixed income, across many sectors, across corporate, government, mortgage-backed securities, the 1-3 year space tends to have a higher Sharpe ratio, so the risk/return profile tends to be better.
At this time, we are not terribly concerned about credit risk. If we look at a company’s balance sheets, they have more cash than they’ve had in the past. Their interest ratios have come down. They have been able to increase prices. There’s some metrics out there saying that 60% of companies tend to increase prices. So the biggest risk is that interest rate risk. We do expect the Fed to hike rates; Chairman Powell came out last week stating that they have met the criterion on their inflation mandate, that they’re a bit more flexible on their employment mandate, and that rate hikes are on the table for next year. The Fed is showing estimates for three hikes next year.
So where do we find income? The front end. With floating rate, you’re still getting around that 4% yield, which, in this environment, with the potential for rising rate environments, we do think that is very attractive.
Also, if we expand the universe — which we have flexible mandates that allow portfolio managers to go out there and find these certain opportunities — we can find opportunities elsewhere. For 2021, that was in taxable municipal bonds, CLOs, non-agency mortgage-backed securities.
Crigger: Do you foresee the opportunity in these sectors to continue in 2022, or has the time passed on them?
Ditri: We do think that munis still offer nice risk-adjusted returns. State and local governments have more cash on their balance sheet and balanced budgets. We’ve seen states, such as Illinois, being close to being downgraded; however, that turned quickly, as the cash infusion started coming in. So we are still bear/bull on municipal bonds. We think that there is more income in the higher-yielding part of that market, but we do still very much think munis have a long runway.
We also think there’s still an opportunity in CLOs. The one concern is that there’s so much supply this year, but we actually think that that is somewhat healthy. CLOs held up very well during the COVID-related sell-off, and on a relative value basis, we like the higher-quality part of the CLOs. They continue to screen cheap, and we think that they’re a bit cheaper than corporates of the same quality. With AAA-rated CLOs, we’ve only seen what we would consider modest widening, despite record issuance, and they continue to scream cheap versus other sectors of the market. We also think that AA-rated CLOs will look good compared to a blend of lower-quality investment-grade, and that the securitized market itself is a place for opportunity going into 2022.
Crigger: For an advisor who may not be as familiar with the securitized space, what should they know about it as they give it a closer look?
Ditri: The securitized market has many, many different sectors. Some of the most common are asset-backed securities. When you’re first taking a look at the securitized market, you can start in those areas, and you don’t need to get to the exotic part of the market. You have residential mortgage-backed securities, commercial mortgage-backed securities, so there’s opportunities in those exposures — they tend to have solid risk/return ratios. But it depends on your level of risk, and that’s why we think it makes sense to have a manager that can go out and find these particular opportunities, because they’re not easy to look up all the details, read the fine print on how they’re paid, when they’re not paid, and so on.
So there are some of the more well-known areas, but then you also have the prime auto and subprime auto loans. There are areas in which we can find opportunity, given dislocations in the market.
Crigger: So the fixed income market is one that really proves the value of active management.
Ditri: Agreed. If you look at the Agg, that benchmark probably has 35% to 40% exposure to U.S. Treasuries. If rates are going up, then perhaps you don’t want to have such a large exposure to U.S. Treasuries. Maybe you want to go out and diversify into asset-backed securities, CLOs, CMBs, high-yield bank loans, and even emerging market corporate debt, which can be issued in U.S. dollars. That debt tends to be high-quality, and it has a risk/return ratio in between U.S. investment-grade and U.S. high-yield.
So we think that the opportunity for active management in fixed income is paramount, because benchmarks tend to be skewed by the largest issuer’s debt. And risk-weighting matters, too. Again looking at the Agg; as of the end of September, it had about 26% of its index in investment-grade corporates. However, that portion made up almost 84% of what we consider the risk-weighted allocation. So just looking at the exposures, really don’t let you know how much risk is associated with those exposures.
Crigger: Speaking of risk, what sort of challenges do you think fixed income investors will encounter in 2022? Will it be more of the same circumstances we saw in 2021, or are there new challenges that investors should start to prep for?
Ditri: The biggest challenges over the past few years is that all risk assets have been driven by monetary policy, fiscal policy, and the overhang of the virus. As we see with the latest strain, that will continue in 2022.
But the biggest change we have seen — and we’ll continue to see — is that central banks in the developed markets have now started tightening. We saw the Bank of England increase rates last week, and the Bank of Norway and the Bank of New Zealand have also raised rates. We’ve seen the Fed come out say they’re going to increase rates. So that extremely accommodative monetary policy in the developed markets is starting to change, and will change, next year. Meanwhile, emerging market central banks have been increasing rates since March of this year, all to do with the big overhang of inflation.
You’ve heard Chairman Powell stating that we should retire the term “transitory inflation.” However, we do think that inflation will come down in 2022. It will take some time, though. Our expectations are not for inflation to be below 2%, as we have been used to for a number of years. We’ve seen ranges anywhere from 2.5% to 3%, but we do think that there are some deflationary pressures. We went back to the averages for the components and subcomponents of inflation and said, “If these subcomponents were to go back to their pre-COVID trends, what would be the impact on inflation?” And we’ve seen the largest component for potential deflation, which has been bringing the inflation headline numbers down, is from new and used vehicles. U.S. car prices have risen significantly, and new car prices have risen due to the supply chain shortages. But we expect that by mid-next year, the supply chain issues will start to resolve, contributing to a decline in that component of inflation. Looking at our internal calculations, we see 3.25% of potential for areas of inflation to come down, almost 2% of that is coming from new and used vehicles.
Crigger: Car sales are a canary in the coal mine. Whatever way inflation is going to go, look to the new and used car sales, and they’ll tell you.
Ditri: Yes. Another, bigger concern is the cost of rent, or owner’s equivalent rent. That will be the part that will drive inflation. That is increasing because it’s been below trend, and so it tends to come in with a lag.
Taking a look at inflation and its prior years’ base effects, we expect core inflation to peak in February or March of next year.
We do expect the energy component — which has been very large past few months — to start to come down, as well. It is tracking to be negative for the month of December, meaning it’s declining from a higher level in November. Those large readings from 2021 will start to come out, and we’ll start seeing inflation coming down, but we don’t expect it to go back to where it was before, below 2%.
Crigger: So still slightly elevated as to where we were from before, but not 10% or 15% or whatever sort of disaster scenario some folks are predicting?
Ditri: Agreed, that’s how we see it. If we take a look at what the Fed discussed last week, they see inflation a little bit higher with its December projections versus those from September, but they still see it coming down year over year. What we think the Fed did is they gave themselves maximum flexibility. They want to end the tapering, the buying of bonds in March, to give themselves the flexibility to raise rates.
Crigger: As we enter this final stretch of the year, many people are making their year-end adjustments. How should investors be positioning their fixed income portfolio moving into 2022?
Ditri: When looking at your fixed income portfolio, you need to ask yourself two questions: Is the purpose of it to generate income, or to provide different diversification versus your equity exposures? When you answer that question, that will help you structure the allocation.
We went back and looked historically at fixed income benchmarks. What actually drives return in fixed income? There’s two components: the price components of buying a bond at par, selling it for more or less; or the income component, which is part of the name of “fixed income.” If you look at the Agg, the standard benchmark over the last 14 to 15 years, we found that about 80% of the Agg’s returns over that time period has come from the income component. But once you move outside of those benchmarks and you start to look at municipal bonds, the front-end investing — bank loans, high-yield emerging markets, and so on — then over 100% of your return comes from the income component.
So, when looking at your fixed income allocation, once you determine the role of that in your portfolio, we think that you find a manager that sticks their philosophy and process, maintains that exposure over the medium term, and income should generate your return.
We do think it always makes sense to have a core fixed income allocation. That should be your ballast for troubles in the equity market. But as we said in the beginning of our conversation, you’re not getting much income in that space. That’s where you can kind of go one of two ways, you find those flexible portfolios that can get exposure to the income-generating sectors, like U.S. high-yield, floating-rate loans, or emerging markets with the portfolio management team determining your exposures or you can create the “plus” exposures with sector specific positioning.
Crigger: Any last thoughts?
Ditri: The one big takeaway I would say for readers should have is that 2022 will be a challenging year, but the U.S. will still be growing at an expected 4% next year. That’s still significantly higher than our long-run average, around 2%. So the growth has been delayed, not derailed. We do expect inflation to decline. We know spreads are tight, but there is opportunity out there to still generate income in the fixed income market, if you take a look at your allocations, give managers some flexibility, and then let the positioning do the rest.
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