Bond Market Expectations

When discussing the bond market, interest rates and the relative sentiment on credit risk (or “spread”) will be the primary drivers of performance on a year-to-year basis.  As a result, 2021 was a relatively weak year for bonds, coming off two very strong years in 2019 and 2020. 

A widely used measure of bond performance is the Bloomberg Barclays Aggregate Bond Index (the “Agg”).  The performance of the Agg was strong for both 2019 and 2020 as interest rates remained near all-time lows. However, as economic growth began to recover from COVID shutdowns, along with supply imbalances that caused higher than average inflation, interest rates rose in 2021.  As always, when interest rates rise, bond prices fall, and 2021 was no exception as the Agg finished the year down 1.54%1

As we turn the clock to 2022, questions about bond price performance remain centered on:

  • Will the economy continue to grow?
  • Will inflation remain elevated, rise further, or begin to decelerate?
  • What actions will the US Federal Reserve be taking with regard to bond purchases and short-term rates?
  • What is the outlook and sentiment on credit risk?

Interest rates have been in relatively steady decline for the past 40 years, reaching all-time lows in August of 2020.  The decline in yields has been a tailwind for bond investors as bond prices have an inverse relationship with interest rates.  In the graph below2, the blue line represents the 10-year treasury rate and the red line represents Inflation.  Recently, inflation has risen quite dramatically, whereas the 10-yr rate has risen but not to the same extent. As a result, “real yields”, or simply the 10-year US Treasury Rate minus inflation rate, is near the lowest levels in history. 

Currently, the U.S. economy is healthy and experiencing above-average growth and significant demand for products and services.  As a result of COVID, supply chains have been unable to meet the level of demand, and as a result, higher prices (inflation) have remained elevated.  It is our expectation that inflation will remain elevated all year, but the level will begin to decelerate towards normalized levels in the back half of 2022. 

Furthermore, when the coronavirus hit the U.S. in February of 2020, the Federal Reserve (the Fed) was very accommodative to the economy by lowering the Fed Funds rate to 0% and began purchasing fixed income securities to support the markets.  In November of 2021, the Fed announced they would begin tapering (reducing) the amount of securities they were purchasing and accelerated the level of tapering in December with plans to eliminate purchases by mid-20223. With regard to rates, the current expectation is now for three rate hikes in 2022 as the economy remains on solid footing, demand is strong, jobs and wages are rising, and the need to keep inflation in check becomes paramount. 

Lastly, credit spread is the amount of premium required to take on default risk.  The higher the default risk, the higher the relative spread.   Through the pandemic, companies were able to strengthen their balance sheets and grow more profitable.  As a result, credit spreads are now near all-time lows as seen in the chart below4.  Our expectation is for credit spreads to remain stable at these levels as we expect US companies to remain relatively healthy and able to repay their debts.

Again, referring back to what drives bond prices:

  • Interest rates: We expect them to be higher at year-end due to economic growth, elevated inflation, and a reduction in Federal Reserve support.
  • Credit spreads: While we don’t expect a significant change, credit spreads are near all-time lows and so this will not be a significant tailwind to future bond market performance

Therefore, we expect 2022 to be another challenging year for bond investors.  Bonds can remain in portfolios to generate some income and reduce volatility, but expectations should be for low positive to slightly negative returns again in 2022.  From a portfolio allocation perspective, we view fixed income as less attractive and have taken small allocations from bonds in our tilt series to be more opportunistic in other asset classes (like stocks).  Lastly, viable alternatives to traditional fixed-income allocations include our Absolute Yield, ETF Endowment-A Series, and our Designed Income strategy.