Reasons for optimism in 2022 - Global Strategic Bonds strategy

Strategy update

There is no doubt that 2021 was a difficult year for fixed income returns in light of the strong rebound in GDP growth and some of the highest inflation prints in many decades, which have followed the gradual unlocking of economies as we cautiously learn to live with the pandemic. Markets have focused on resulting expectations for central bank policy, with interest rate rises and the tapering of asset purchasing programmes high on the agenda. Unsurprisingly in this environment, duration-sensitive assets struggled in 2021. However, asset classes such as high yield – driven by low default expectations and tightening credit spreads, as well as inflation breakevens – fuelled by rising inflation that proved not to be as short-lived as central banks expected, fared much better. The story was more complex for emerging markets, which notably suffered from heightened volatility in Asia – particularly in the Chinese property sector.

The Global Strategic Bonds strategy delivered a flattish return in 2021, with an absolute performance of +0.30% (gross of fees in USD). Since inception in May 2012, the long-term performance of the strategy remains very attractive, with a cumulative total return gross of fees in USD of +58.73% (+4.91% annualised).¹ Despite a tough start to 2022, here are some reasons why we believe the case for a flexible, unconstrained approach to fixed income investing remains a compelling proposition.

Reasons for optimism

Market pricing for monetary policy may be too aggressive

In many ways, 2021 was defined by market expectations for central bank policy in the wake of higher inflation data, which provided to be stickier than originally anticipated, along with strong growth as economies kicked into life again. 2022 should see a continuation, and even escalation, of the “reopening” theme. However, central banks face a difficult balancing act between “normalising” policy to tackle inflation, whilst ensuring that growth remains robust. Therefore, as the market aggressively prices in interest rate rises (in the US, the market is now pricing in four Fed hikes in 2022), it is perhaps worth considering the potential for central banks to disappoint the market – given the current starting point of incredibly loose policy and an uncertain outlook. We also remain firmly in the camp believing that inflation should subside in 2022 as supply chain issues subside, demand normalises somewhat, and attention turns once again to the deflationary impacts of ageing demographics, globilisation and an increased reliance on automation and technology. No doubt we will move to tighter financial conditions in 2022 and rate rises are inevitable (indeed the Bank of England have already hiked in December), but the more aggressive market pricing for rate rises gets, the more excited we get about the potential opportunity.

Higher yields, higher carry

Fixed income can often be simplified: what we are witnessing at the moment is an asset class that is getting cheaper. For many investors, particularly institutional – who are less price sensitive but need to own high quality government bonds for regulatory reasons – the valuation argument for buying bonds is strengthening by the day. Clearly, timing is key and many will be cautious that yields may have some way to go higher still, but just like Q1 2021 when everyone fixed on US 10-year treasury yields going through 2% (they peaked at 1.75%), there is a level at which cheaper bond yields may become too much for many to resist – thereby creating a powerful technical demand for the asset class – particularly if the economic recovery hits further bumps in the road. It is worth considering also that credit spreads are at historic tights following the recovery since March 2020 and that any sort of repricing could be perceived as a buying signal for many.

Consecutive negative years for bond returns are very rare

In 2021, developed market government bonds unanimously delivered a negative calendar year return. It is worth noting that this is a pretty rare occurrence. Taking the broad US treasury market as an example, 2021 was just the fifth negative return year since the index began in 1978 (i.e. 44 calendar years). More notably still, there has never been consecutive negative return years. In fact, the years after a negative return have tended to bounce back strong: in 1995 the treasury market delivered a +18.5% return, whilst in 2000, 2010 and 2014 it posted +13.4%, +5.9% and +6.0% respectively. Although we would clearly stop short of guaranteeing a similar outcome in 2022, the same logic applies that, after a sell-off, a recovery tends to follow. Emerging markets is another asset class to watch in this respect after a difficult 2021. Sentiment towards fixed income is pretty low at the start of 2022, meaning that it shouldn’t be too difficult for it to surprise investors to the upside!

Appetite for risk remains strong

Despite the emergence of the Omicron variant, the outlook is still positive for high yield. We do not see default rates moving much off historic lows and Covid-related growth scares could keep the Fed from tightening too much, which could be positive for high yield if there still is some growth. While acknowledging some outflows from retail investors, appetite for the asset class remains strong as global fixed income markets still offer little yield for institutional investors and the US HY default rate remains at record lows. Recent market weakness has slightly improved the total return outlook for the US HY market, which should help with market sentiment as investors analyse their asset class allocations for 2022. From a technical supply/demand perspective, we see positive drivers due to the amount of potential rising stars next year and beyond, with an estimated $80-120bn of bonds to be upgraded to IG in the near future. This means that those bigger issuers will fall out of the HY index and become IG issuers.

Fixed income is not one asset class

Underpinning all these convictions is the ultimate belief that a diversified and flexible approach to fixed income can deliver attractive risk-adjusted returns over an economic cycle. 2021 was another reminder that, although government bonds and emerging markets lost money, there were strong positive returns in inflation-linked assets and high yield. Our simple and transparent investment framework, founded on three “risk buckets” (Defensive, Intermediate and Aggressive), allows us to access a broad range of fixed income asset classes where we can own bonds with negative yields all the way to double digit yields. With this broad opportunity set at our disposal, we remain convinced that there is money to be made in fixed income in 2022 and beyond.

The strategy is actively managed without reference to any benchmark.