2022 is shaping up to be a tough year to navigate, especially in bond markets. Transient inflation proves anything but, and US and UK central banks seem undecided on whether interest rates should rise or not. The concern is that a mistake – especially on the part of the Fed – could send markets routing.

So how do you invest in fixed income in this environment? As Juan Valenzuela, co-manager of Artemis Target Return Bond points out: “To say that a long period of high inflation would not represent a benign environment for fixed income securities as an asset class would be an understatement.

There are, of course, ways to mitigate the risk of inflation. One is to reduce duration and therefore limit overall sensitivity to yield movements. This should also help limit the falls in the event of a disorderly sell-off in the bond markets. But on the other hand, it would hamper returns if yields were to fall.

High yield outlook looks ‘compelling’

High yield bonds are another option. They tend to be shorter in duration than the broader fixed income universe and also tend to perform strongly in periods traditionally associated with higher inflationary pressures.

The recent high-yield bond sell-off, which has been ongoing since late September, has injected some value into the asset class, and default rates also remain low due to central bank support. JP Morgan recently revised its high yield bond default rate for 2022 to 0.75%, and to just 1.25% for 2023.

“While these low default rates are very supportive in the near term, participants expect them to persist in the medium term, in a positive backdrop,” said Chris Holman of Twentyfour Asset Management. “Furthermore, against the backdrop of a long-term average default rate of 3.6% for high yield bonds, current defaults are at very low levels. Therefore, with forecasts remaining weak and credit fundamentals as supportive as they are, the outlook for the asset class continues to look attractive.

It’s also worth remembering that high yield is a fairly small market, relatively. Therefore, it does not take much technical effort to make a good year. But likewise, it won’t take much to go the other way either.

It’s time for emerging debt to shine

The bonds of some emerging market economies, particularly commodity exporters, may also perform better than expected in times of inflation – as was the case in 2021. “Oil and gas prices, and other commodities, are supporting emerging markets linked to them, with good real and nominal growth,” said Claudia Calich, head of M&G Emerging Markets Bond.

“Many emerging market central banks have already hiked rates and plan to do so again in the near future,” Calich said. Emerging markets probably did the heavy lifting long before the Fed and other big banks.

“Emerging markets investment grade is expensive, both at the corporate and government level. It is in the high yield component – ​​both sovereign and corporate – that the best opportunities lie.

And while different emerging markets have different economic scenarios to deal with, so do developed markets. While the UK and US could hike rates imminently, few expect the ECB to raise before 2023, for example.

“We expect to see significant divergence in the trajectories taken by individual economies,” Valenzuela said. “Differences in the size and composition of fiscal support offered by different governments, and the varied sectoral exposure of their economies, will cause economies to recover at different paces – and therefore produce different outcomes for inflation.”

When in doubt, look for flexible managers

But then, what if the current variant of Covid turns out to be a game-changer again and recovery is put on the back burner?

As we have seen over the past few years, Treasuries have been a safe haven for many investors when the markets are spooked. “Even in the low-yield environment that we have been experiencing for years, fixed income securities have fulfilled their role of preserving capital,” said Flavio Carpenzano, chief investment officer at Capital Group. “Despite potential short-term losses in the market, mid-term (3-year) bonds have consistently provided positive returns.”

With so many unknowns at the start of the new year, it seems logical that investors should not attempt to make those calls themselves. Indeed, has there ever been a better time to allocate fixed income exposure to a strategic bond fund that is rapidly moving between all of these fixed income asset classes as the environment changes?

My fund picks in this sector are: Aegon Strategic Bond for its very active and flexible approach which has really paid off over the past three years; Baillie Gifford Strategic Bond for his focus on the sheer prowess of stock picking; Allianz Strategic Bond for its low correlation with equities and its focus on the macroeconomic environment and interest rates; and Jupiter Strategic Bond for its conservative approach and focus on limiting downside in tough markets.

By Darius McDermott, Direct Manager, Chelsea Financial Services, 14 Jan 22