4 min read 22 Feb 22
The fixed income sector faces a number of developing headwinds this year, from sharply rising inflation to the expectation of significant interest rate hikes and the gradual reduction of quantitative easing in developed economies, a potential energy crisis, and geopolitical risks.
Higher inflation – and whether it is likely to prove temporary, as central banks have argued, or more persistent – is the core issue. It is still possible to believe the inflation spurt will prove temporary, but that is becoming less credible as time passes. The US Federal Reserve (Fed) has decided upon imminent action, with chairman Jerome Powell recently saying he anticipates a series of rate hikes this year, along with reductions in the level of extraordinary support.
Inflation is a global theme, but the extent of the problem varies by region. The Bank of England (BoE) has already lifted borrowing costs while the Fed has signalled that hikes are looming. Meanwhile, interest rate rises in the eurozone, where inflation is more subdued than in the UK or the US, are several months and possibly up to a year away.
Further down the line, one key challenge that will emerge for the Fed and the BoE will be in determining whether the monetary tightening cycle has been sufficient, or if further action is required.
While markets are currently focused on the timing and extent of interest rate hikes, central banks are likely to combine higher borrowing costs with a reining back of bond purchases once the initial phase of rate hikes have been implemented. That could leave bonds, particularly long-dated bonds, vulnerable as investors reprice those assets, and yields on both shorter- and longer-dated government bonds move higher.
Unlike purchasers of government bonds, such as US Treasuries, investors in corporate bonds expect to be compensated for the risk of investing in the sector.
The rise in inflation and the prospective tightening of monetary policy will affect corporate bonds in two main ways. First, inflation is having a negative impact on corporate balance sheets, with some sectors, such as leisure and manufacturing, particularly hard hit as they struggle to attract labour and are forced to raise wages. That is affecting the prices of their bonds.
At the same time, higher interest rates – and the prospect of a reversal from quantitative easing to quantitative tightening – will impact investment flows into corporate bonds, driving yields higher.
This environment is creating many opportunities among distressed companies that are able to survive, restructure if necessary, and rebuild margins as a result of resilient balance sheets, management expertise and factors such as pricing power.
But rather than simply buying into short-term price weakness in the belief that central banks will always unleash fresh support to financial markets, investors should learn to be patient.
Central banks are likely to focus on wider factors such as containing inflation, rather than propping up asset prices at the first sign of weakness. Investors who conduct a thorough analysis of individual companies will be able to find pockets of value as spreads widen meaningfully over the year.
The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.