The necessity of yield in 2022
Janus Henderson Investors
No pain, no gain. At least that's the old saying. But portfolio management is a well-developed science of managing risk, of finding large or small opportunities that - when combined in a diversified portfolio - may produce a little bit more return with the same risk as a passive benchmark, or the same return with a little less risk. Or, ideally, some combination of both. As such, portfolio management is the science of finding as much gain with as little pain as possible and, in our view, 2022 is likely to be a year where active portfolio management could shine.
If the second half of 2020 was an environment where a bond investor wanted as much corporate credit risk as possible (taking advantage of hugely dislocated valuations because of COVID-19), we think that opportunity largely ran its course in 2021. Investment-grade corporate bond spreads could tighten further by the end of next year. But if they do, it is more likely to be modest than not. And if they don't, the relatively small yield they offer does not provide much return for the risk tolerance such a position requires. When the Bloomberg US Aggregate Bond Index is offering a yield of just 1.7%,1 it just doesn't take much of a rise in interest rates or a widening in corporate bond spreads to risk giving it all back.
Corporate fundamentals remain robust
This doesn't mean we aren't positive on the outlook for the US economy, and select pockets of the corporate bond universe. We are. Broadly speaking, corporate fundamentals are still strong in aggregate, with consensus earnings-per-share (EPS) growth estimates for the S&P 500® Index near 7.5% for the next 12 months.2 And, historically, corporate bonds have performed well during the early part of a US Federal Reserve (Fed) tightening cycle. In 2016 and 2017, for example, the Bloomberg US Corporate Bond Index returned 6.1% and 6.4%, respectively.3 It wasn't until toward the end of the tightening cycle, in 2018, when performance suffered, and the index fell 2.8%.4 However, current valuations suggest this effect may already have been anticipated. Because, despite the recent uptick to near 1.0%, spreads of the Bloomberg US Corporate Bond Index remain near historical tights.5
But if investment grade corporate credit has, historically, performed well during the early part of tightening cycles, the high yield market has been even more impressive. In 2016, for example, the Bloomberg US High Yield Index returned 17.2%,6 which makes some intuitive sense. After borrowing substantial sums when official interest rates were relatively low (and they were 0% in 2020 and 2021), many companies' liquidity profiles improved significantly. Now, flush with cash and the expectations that income could potentially remain strong on the back of a still-recovering economy, more companies have begun a process of repairing their credit profiles.
High yield bond spreads, like investment grade corporate bond spreads, may also be pricing in much of the good news. But high yield is different in that the significantly higher yield the index pays is meant to be compensation for defaults. And the outlook for defaults has rarely looked so good. The current "stress ratio" (that is, the number of bonds trading below 80 cents on the dollar), which can be a great indicator of default rates, has improved dramatically in recent quarters. Indeed, we believe corporate bond defaults peaked in early 2020 and expect they will decline further in 2022. Simply put, when defaults (pain) are expected to be low, the relatively high yields (gain) being offered deserve the attention of active portfolio managers. While it helps that the Fed, as recently as 2020, signalled it would support the high yield market should a major crisis occur, we think the asset class' risk/reward profile remains a bright spot in an otherwise low-yielding/tight-spread world for government and corporate bonds.
In our view, volatility in the high yield market is more likely to come from external, macro factors than from concern about any individual sector or company. The Fed is expected to begin an interest rate tightening cycle next year and while that is usually cause for caution, the recent surge in inflation and the uncertainty about how fast it may fade are likely to add to the uncertainty. Volatility should also be expected from both good and bad news regarding the COVID-19 virus. On the one hand, news like Pfizer's COVID pill is cause for celebration, while the emergence of the Omicron variant is more concerning. Most importantly, we expect volatility in 2022 - whatever the cause - may have an outsized impact on returns, given how low government and many corporate bond yields are today.
This is not to suggest that investors should rethink their overall allocation to bonds. On the contrary, we believe a core allocation to bonds can often play an important role in reducing the volatility of an investor's overall portfolio. But with yields as low as they are, more - and more active - portfolio management, in our view, is needed. As we do not believe the Fed beginning to raise interest rates or new variants of the COVID-19 virus will add enough uncertainty to derail an economic recovery of the magnitude we see across the globe, we think investors should stay invested in bonds. But some diversification would help, and - where fundamentally appropriate - favouring higher yielding securities may help thicken the yield cushion against future volatility.
1Bloomberg, as of 3 December 2021.
Credit spread/spread: The difference in yield between securities with similar maturity but different credit quality, eg, the difference in yield between a high yield corporate bond and a government bond of the same maturity. Widening spreads generally indicate deteriorating creditworthiness of corporate borrowers, and narrowing spreads indicate improving creditworthiness.
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