Fundamentally the outlook for 2022 appears less supportive than it was 12 months ago. GDP growth is likely to slow and we expect underlying rates to gradually increase across established markets, a combination that typically leads to a pick-up in the default rate and a degree of credit spread widening. In such an environment, where the dispersion in performance across corporate and high yield bonds is also expected to rise, bond selection naturally becomes a more decisive factor in returns.
Despite this more challenging outlook, we do continue to see pockets of value which, when combined with judicious portfolio allocation, should mean investors can achieve reasonable returns from fixed income in 2022.
The first headwind for investors to consider is duration. Interest rate swaps are one way to address this, but selecting bonds with particular characteristics can be equally effective in a rising rate environment. In particular, bonds that benefit the most from roll-down – the natural spread compression that occurs as bonds approach maturity – can significantly mitigate duration risk.
Every bond that reached its original maturity date benefits from roll-down (this obviously excludes those in default or restructuring situations). Very early in an economic cycle, investors tend to benefit the most from roll-down at the long end of the curve when credit curves are steep. However, credit now looks to be in mid-cycle and over the last 18 months credit curves have flattened. As we move towards the next stage of this rapidly progressing cycle, the short end of the curve should steepen on a relative basis, and thus shorter dated bonds (especially the 3-5 year bracket) tend to offer investors the most in terms of roll-down gains. Importantly, however, capturing this roll-down at the short end of the curve is only really effective if you’re buying bonds with enough spread to absorb anticipated rate rises.
With rock-bottom default rates and overwhelmingly positive ratings migration, 2021 hasn’t exactly been the hardest year to be a credit analyst. Things will get a little tougher in 2022 as we expect ratings migration to moderate, though we think upgrades will continue to outweigh downgrades over the medium term. In European high yield, for instance, we are forecasting 1.5 upgrades for every downgrade in 2022, down from around 2 upgrades per downgrade year-to-date in 2021.
This projection should surprise no one; financial conditions will weaken, but growth is forecast to remain above cycle averages and borrowing costs should stay at a manageable level for issuers. Dispersion, however, should increase and therefore stock-picking will become more important to fixed income portfolio managers in 2022. As a result, credit analysts will likely focus on those companies that are able to improve their balance sheets, generate healthy cash flow and manage inflation effectively.
We are still at a relatively early stage of the economic cycle, and though defaults are set to increase from here, they are expected to remain well below the long term average for some time yet. So while we think caution on CCC rated issues is sensible at this point, we do see value in selectively descending the rating spectrum in credit. Bonds in rating bands where the default rate should remain low but spread levels are still attractive should be the sweet spot for credit in 2022, particularly at the shorter end of the curve.
In our view, next year will be less about capital gains and more about smart defensive positioning. As default rates and dispersion both increase, investors will need to be more vigilant with their credit selection. However, we still see enough opportunities in shorter duration assets with healthy spread levels to allow credit analysts to feel optimistic about solid returns in 2022.