A brighter future for fixed income?

April 3, 2022

David Bailin

Chief Investment Officer and Head of Citi Global Wealth Investments

Steven Wieting

Chief Investment Strategist and Chief Economist

Bruce Harris

Head of Global Fixed Income Strategy

SUMMARY

For bondholders, 2022 may feel like the “worst of times” with certain fixed income holdings offering their worst total return to begin a new year in decades. Despite such results, we believe fixed income will become an important element for client portfolios in 2022.

The US Federal Reserve’s policy pivot completely altered rate expectations. The 2-year Treasury yield now embeds one of the sharpest and fastest expected increases in policy rates in US history for any 12-month period year. As of April 1, the yield on the 2-year had risen 173 basis points YTD – nearly 113bps of which happened since the beginning of March.

Despite these movements, we believe fixed income will be a key allocation of portfolios in 2022. The sharp selloff this year in bonds has opened up an opportunity to invest at a relatively higher yield point, with most of the expected interest rate hiking cycle likely already priced in. We also think the value of fixed income in portfolios is now higher than it was in 2021.

Blame the sudden “Powell pivot” for the unilaterally bad performance in bonds. Last November, Fed Chairman Powell noted that the Fed had lost its patience with inflation after attributing most of the distortions in consumer prices to the pandemic.

Now, even with the Russia-Ukraine conflict, Covid spiking in China and a doubling of supply shocks in energy and agricultural commodities, the Fed remains emboldened to continue its hawkishness.

It would be risky if the Fed was “just” increasing rates this rapidly. But it’s also likely to cut the size of its balance sheet at the same time, which will further reduce market liquidity. We think the Fed may be overestimating the strength of the economy and its ability to withstand higher rates and reduced financing.

Overall, we believe the majority of the mark-to-market losses for the fixed income asset class may already have been realized. The extremely fast selloff this year in bonds could be an opportunity to invest at a relatively higher yield point. We believe that peak rates for fixed income in this cycle will be reached in 2022, creating buying opportunities.

We also believe that the value of fixed income in portfolios is now higher than it was in 2021. At present, bonds add both income and possible protection from extreme downside equity risks.

AAA-rated bonds such as US Treasuries are unlikely to see permanent losses, even if rates move higher. Any mark-to-market losses are an “opportunity cost” of not being able to invest at a higher yield.