Favouring stability in US fixed income in 2022
Head of US Securitised Products John Kerschner explains why investors should consider sectors and securities that are less likely to be impacted by volatility in interest rates and have the fundamental strength to tolerate any greater-than-expected weakness in the economy.
- Surging inflation and a resurgence of COVID-19 fears fueled by the Omicron variant raise an important question: Are financial markets too sanguine about the risks in 2022?
- As many investors have realised substantial gains in equities and credit markets over the past year, rotating to investments that may offer lower returns, but less chance of generating negative returns, could prove to be prudent.
- In particular, sectors and securities that are less likely to be impacted by volatility in interest rates and have the fundamental strength to tolerate any greater-than-expected weakness in the economy should be favoured.
Just a few months ago, most investors probably thought 2022 would be a relatively sanguine year. The economy was slowing but still strong, the U.S. Federal Reserve (Fed) was expected to taper its bond purchases but remain accommodative, and the market generally believed the Fed would be patient about raising interest rates. But surging inflation and a resurgence of COVID-19 fears fueled by the Omicron variant are understandably raising questions.
Perhaps the most important of those questions are whether markets are too sanguine and whether prices in both equities and credit markets are thus precariously high. We know of no established forecaster expecting another year of 20%+ returns in stocks, nor any who think bonds (broadly) could see double-digit returns in the year ahead. If the risks that must be taken to achieve the reward that is expected have shifted for the worse, what should a bond investor do?
Insofar as portfolio management is essentially the management of risk with the goal of building a diverse set of opportunities that have the highest expected risk-adjusted returns, we think the answer is relatively simple: refocusing bond portfolios into sectors and securities that are less likely to be impacted by volatility in interest rates and are expected to have the fundamental strength to tolerate any greater-than-expected weakness in the economy. To answer the same question more quantitatively, we think 2022 may prove to be a year where favoring investments that offer the prospect of lower returns, but less chance of generating negative returns, may (thanks to the power of compounding returns) prove to be prescient.
Put more concretely, we think beginning to rotate credit exposure from corporate bonds to securitized products may prove prudent over the course of the year. As for interest-rate exposure, we remain optimistic that longer-maturity yields are unlikely to rise substantially, but at the same time do not think they will fall dramatically. As such, their relatively low yields do not offer much cushion to mitigate any short-term volatility. Therefore, favoring lower duration (a measure of sensitivity to interest rates) securities also seems prudent.
The underlying fundamentals for securitised products are generally still positive
Home prices in the U.S. are likely to end the year up more than 20%. While we expect that will slow in 2022, consensus expectations are for a further 5-10% rise.1 Given that mortgage rates are still relatively low and there remains pent-up demand for houses and not a lot of supply, it is hard to imagine a bearish scenario for home prices. Rent increases are tough on consumers but good for the multi-family housing market. Similarly, in the industrial mortgage space, more online ordering has raised demand (and rents) for warehouse space, benefiting commercial mortgage-backed securities (CMBS).
Despite the talk of the Fed tapering its MBS purchases, we believe the supply/demand outlook is still positive for MBS. We expect supply to slow significantly in 2022 as the refinancing wave driven by extremely low interest rates runs its course. Refinancing of existing mortgages reached a high of 85% this year and thus new issuance of MBS in 2021 is approaching $900 billion, an all-time high. From those highs, refinancings have fallen back to about 40%, and we think they will go even lower next year as rates are likely to creep higher.2
Meanwhile, the consumer savings rate is still high, at around 7.5%.3 This is good news for many asset-backed securities (ABS) and other securitized products that are more directly linked to consumers than companies. With the availability of jobs possibly as high as it has been in many job seekers’ lifetime, and one recent study estimating that only 29% of total stimulus checks have been spent,4 we think consumers, in aggregate, will probably be as strong – if not stronger – of a credit risk in 2022 than they were in 2021.
Lower duration holdings can help mitigate interest rate volatility
The vast majority of ABS can be broadly classified as “short-duration” securities with maturities less than five years, and thus could offer more attractive risk-adjusted returns in periods of high interest rate volatility. Furthermore, various sectors within securitized products offer floating interest rates, including many CMBS and the bulk of the collateralized loan obligation (CLO) market. Floating-rate securities do not have a “fixed” interest rate like traditional Treasury bonds or most corporate bonds. Instead, the yield they pay “floats” on top of a benchmark, such as the Fed’s short-term policy rate. As such, when the Fed raises their benchmark rate, the interest paid on a floating-rate security linked to it tends to rise.
Between shorter-duration and floating-rate securitized products, we think some investors may have an opportunity to position part of their portfolio into securities that are likely to be less sensitive to volatility in economic data or interest rates, while still paying relatively attractive yields. Currently, the J.P. Morgan AAA CLO Index has an average yield near 2.2% and the BBB Index, which is still investment grade, is yielding 4.9%.5 While these yields take the Fed rate hikes already assumed by the market into account, when they are compared to the 1.7% yield currently offered by the Bloomberg U.S. Aggregate bond index,6 which has a much longer duration, we think CLOs look attractive at both the lowest and the highest investment-grade ratings.
Finally, we believe the securitized products sector also provides more opportunities for security selection, which can help both improve a portfolio’s diversity and its risk-adjusted returns. The supply of new securities in 2021 has reached all-time highs in the CLO market, and the number of new issues in CMBS and ABS are up over 50% year-on-year.7 In our experience, there are currently numerous opportunities to find undervalued securities or just individual issues that have a modestly better expected risk-adjusted return.
Being portfolio managers, we believe the combination of careful security selection and thoughtful sector allocation, through a robust portfolio construction process, could help investors achieve a little more stability in bond returns in 2022. It might sound somewhat boring, but sometimes it’s better to be careful. In other words, it might make sense to protect the gains your portfolio may have recently delivered from the equity or credit markets and be in a better position to take advantage of any opportunities short-term volatility creates in the months and quarters ahead.
1Bloomberg, as of 3 December 2021.
2Bloomberg, as of 3 December 2021.
3Bloomberg, as of 3 December 2021.
4NY Federal Reserve, as reported by Jefferies, as of 3 December 2021.
5Bloomberg, as of 30 November 2021. Indices are the J.P. Morgan CLO AAA Total Return Index and J.P. Morgan CLO BBB Total Return Index. The J.P. Morgan CLO index captures the USD-denominated CLO market, representing over 3000 instruments, while sub-indices (used here) are divided by ratings and ranging from AAA through BB.
6Bloomberg, as of 3 December 2021.
7Janus Henderson, as of 3 December 2021