4th Quarter 2021 Fixed Income Review
• Q4 fixed income markets experienced generally negative performance and Treasuries and most high credit quality indices were negative for the year
• Inflation soared to levels not seen in twenty years due to disrupted supply chains and product and materials shortages with the reopening of the economy
• FOMC started reducing, or “tapering”, its asset purchases in November and will accelerate that wind down this month with the program expected to end in March
• Despite continued low yields, U.S. Treasury yields are among the highest in the developed world continuing to attract foreign buyers
Higher inflation expectations and hawkish leaning statements from the FOMC led most fixed income markets to experience flat to negative returns in the 4th quarter of 2021 while U.S. equity markets broke records. Increased global growth and higher inflation expectations gave many risk investors a green light. In following, higher risk sectors of fixed income also exhibited good relative performance during the year. Lower credit quality, such as high yield municipal and U.S. corporate high yield, were notable with each index returning in excess of 5.00% during 2021 as investors accepted the risks in their continued search for higher levels of income.
Below are 4th quarter and 2021 annual Bloomberg Barclays fixed income index returns:
The 10-year U.S. Treasury (UST) note, a bellweather measure used in the fixed income markets, ended 2021 with a yield of 1.49%, compared to 0.91% at the end of 2020. The 2-10-year UST yield spread, an often-cited measure of the slope of the yield curve, ended 2021 at 78 basis points after averaging above 100 bps for most of the year. For reference, that same 2-10-year yield spread has averaged around 60 basis points for the past five years. The UST yield curve “flattened” during Q4 with shorter term yields rising more than longer term yields in anticipation of a change in Fed policy. When not participating directly in the open market with purchases or sales, the FOMC only directly controls the overnight “Fed Funds” rate.
The chart below shows the changes in the UST yield curve from the end of 2020 (gold line) and the end of 2021 (green line). The bar graph at the bottom shows the changes in yields for select maturities.
In December, Federal Reserve officials announced a step-up in their reduction, or “tapering”, of monthly emergency asset purchases of Treasuries and mortgage bonds begun during the pandemic to support liquidity and stabilize markets. At the current $30 billion per month pace of reductions the U.S. Treasury markets reflect a complete winding-down of the emergency program by the end of the first quarter.
Although the FOMC left interest rates unchanged in their most recent meeting, Federal Reserve officials signaled that they were prepared to raise the short-term Federal Funds rate at least three times during 2022 in an effort to cool inflation. The FOMC has indicated it wishes to end asset purchases before lifting short-term rates and speculation has increased the Fed may allow its sizeable balance sheet to run-off more rapidly than previously forecast. Not surprisingly, fixed income markets began adjusting with yields rising (bond yields move in the opposite direction of prices) in late December. That trend has continued into early January with the 10-year UST rate currently above 1.75%.
Additionally, the FOMC updated predictions for GDP, inflation, and unemployment in December. Notably, the Fed’s median estimate for the core Personal Consumption Expenditures Index (PCE), the central bank’s preferred measure of inflation, soared during 2021 with the PCE rising to 4.7% annualized in November. The measure is expected to end the year at 4.4% annualized.
Similar to domestic yields, foreign bond yields generally increased during 2021 as several foreign central banks have followed the Fed’s lead and begun to telegraph tighter monetary conditions in response to inflationary pressures. Globally, negative yielding debt outstanding dropped markedly from almost $18 trillion in December 2020 to around $11 trillion at the end of 2021.
Below, in blue, are 10-year bond yields from several foreign countries (sorted from low to high), as of the end of 2021. The wide disparity between the yield of the German Bund (the German ten-year note- often considered a proxy for European yields) at -0.19% compared to the U.S. ten-year note at 1.49% is indicative of two very different economic outlooks and divergent central bank monetary protocols. The graph provides a good visual. The high relative yield of U.S. Treasuries and other high-quality domestic fixed income sectors continue to draw a great deal of support from foreign buyers.
2021 was a challenging year for fixed income investors to say the least. The outlook for inflation, and commensurate near-term FOMC activities in response, will likely continue to create interest rate headwinds for the foreseeable future as the Fed works to slowly increase overnight rates. In following, we currently recommend patience and higher cash balances than normal in anticipation of higher rates down the road. Core fixed income portfolios should maintain shorter duration and higher credit quality. Longer duration bonds should be avoided. There are also several ultra-short bond funds currently approved to augment cash flows and enhance cash positions where appropriate.
Although positive nominal rates are still available in higher risk sectors of fixed income, taking current and near-term inflationary measures into account, U.S. real rates on higher quality fixed income are generally negative. Our higher risk allocations in actively managed high yield corporate and municipal bond funds performed well in 2021 but we do not anticipate outsized returns going forward as these sectors currently trade near historically tight levels. We do however expect to earn the higher “coupon” in these strategies and have recently recommended a shift into an actively managed floating rate fund for added diversification.
We hope you will contact your portfolio manager, or any member of our fixed income team, to discuss our thoughts on fixed income, and to learn more about opportunities we believe are both appropriate and timely.
Not Investment Advice or an Offer | This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing. Argent Financial Group is the parent
company of Argent Trust, Heritage Trust and AmeriTrust.
For more information about the commentary found in this newsletter, please contact: Sam Boldrick: sboldrick@argenttrust.com or Hutch Bryan: hbryan@argenttrust.com
