Why Investors Should Rethink Fixed Income | ETF Trends

The year is shaping up to be one of market volatility, higher interest rates, and tighter liquidity. However, while 2022 will be challenging, it could provide some great buying opportunities within credit markets. So, fixed income investors should adopt a more flexible approach to bond investing, argues a recent white paper from T. Rowe Price.

Arif Husain, head of international fixed income and lead portfolio manager for the Dynamic Global Bond Fund at T. Rowe Price, writes that this year “could be a roller‑coaster ride for bond investors,” with major central banks likely pulling back from supporting markets after putting stimulus measures in place for more than a decade. The withdrawal of central bank liquidity, along with rate hikes in some countries, will come while governments are also scaling back levels of fiscal support. The convergence of these factors will likely push up most government bond yields.

Prepare for Tightening

Just as inflation reached unexpected levels last year, so could bond yields this year. Since no one knows the pace of tightening or how many central banks will join in, the road towards higher rates will likely be rocky. While the European Central Bank seems hesitant to move this year, Husain notes that it could end up being decisive for bond markets if inflation forces its hand.

Balance sheet reduction is also possible. If multiple global central banks shrink their balance sheets at the same time, it may have far‑reaching consequences, since this situation is untested in bond markets.

While such an environment could be challenging, it could lead to valuations turning attractive with potentially great buying opportunities emerging.

In this environment, managing duration actively will be critical. This approach allows investors to tactically respond to different market environments and regime changes and gives investors the flexibility to take advantage of any pricing anomalies that might take place in a volatile environment.

Credit Markets Aren’t Immune From Volatility

With defaults expected to remain low, the fundamental credit environment will likely stay strong in 2022. Despite this, it’s unlikely to save credit markets from volatility.

A key risk is the possibility of waning liquidity support as central banks wind down their quantitative easing programs. The likely tightening in financial conditions may cause turbulence in a risk‑sensitive market like credit.

And as valuations tighten, “there’s less of a cushion to absorb interest rate volatility,” Husain writes. “This matters because credit contains a duration component that exposes it to changes in interest rates—a risk that is not always fully understood by investors.”

A defensive approach could work well in this environment, since hedging strategies are often deployed to help navigate volatility. Managing duration actively is also critical considering the duration risks to which credit portfolios may be exposed.

Stock/Bond Correlations Are Changing

Investors frequently presume that fixed income performs well when equities sell off. This has meant that government bonds have often been used to mitigate risk. But at current rates, T. Rowe Price expects government bonds to be a less effective diversifier than they’ve been in the past.

Plus, the relationship between stocks and bonds is not always consistent. For much of the 1990s, the connection between the two was positive. But as monetary support is withdrawn, markets are set to undergo substantial change. So, it’s possible that stocks and bonds may both sell off simultaneously at times in 2022.

A broad approach that deploys the full toolkit, including currency and derivatives markets, may help to balance and mitigate risks in a portfolio.

“Overall, we believe this environment is conducive for our approach, which is flexible; emphasizes active duration management; and the implementation of defensive hedges to help provide diversification against risk assets,” writes Husain.

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