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Fixed Income Monthly

By Richard "Crit" Thomas, CFA, CAIA
Income Investing
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Since the last edition:  Indications that the COVID-19 Omicron variant results in more mild conditions allowed for a relief rally in credit exposed securities while U.S. Treasury yields moved back up and prices down. Still the yield on the 30 year Treasury bond closed the year with a yield below 2% indicating a lack of concern for longer-term inflation among investors. Option adjusted spreads for the Bloomberg U.S. Aggregate Corporate Bond Index narrowed by just 6 basis points during the month, while spreads for the Bloomberg U.S. Corporate High Yield Index narrowed by 50 basis points. Spreads for floating rate bonds narrowed by 34 basis points.

In December the U.S. Federal Reserve Board (Fed) announced an acceleration in the pace of tapering with an expectation of ending its quantitative easing (QE) program by March 2022. The fixed income marketplace was already preparing for a more aggressive approach to tapering. As such there was limited response to the news in the bond market. More important is when the Fed begins raising the Federal Funds rate and at what pace. We believe that inflation will moderate in 2022, though remain above the Fed’s target rate. A moderating rate of inflation should allow the Fed to take a measured approach to raising rates and we believe three rate increases of 25 basis points each is a reasonable expectation for 2022.

Thematic Backdrop

  • Interest Rate Risk: We continue to suggest that investors hold duration slightly shorter than the benchmark. Our relative value model suggests the 10 year Treasury yield should currently be in a range of 1.70%-1.80%. Looking out into 2022 and 2023 we see the potential for yields to move toward 2%, though if the Fed were to embark on a more rapid rate rising policy path or a more worrisome COVID-19 variant crops up it could forestall this outlook.

  • Credit Risk: Loose financial conditions and a recovering economy have led to ratings upgrades and fewer defaults, supportive of lower quality credit securities, but are not likely to improve any more. Meanwhile spreads (a measure of valuation) remain low in a historical perspective. Absolute yields for below investment grade bonds do remain attractive relative to higher quality credit securities, though we believe investors should become more selective and move to a strategic allocation in high yield bonds as opposed to an overweight.
  • Fed Policy: Remains accommodative with the Federal Funds rate anchored near zero, though it has sped up its tapering of QE purchases. The question is what happens with the Federal Funds rates in 2022. Currently the market is discounting three 25 basis point rate increases and that is consistent with the Fed’s dot plot. We believe the rate of inflation will shift lower as we move through 2022 and see a risk (opportunity?) for inflation to come in below expectations as tight supply conditions unwind faster than expected. If this were to occur the Fed may not raise rates as soon or as many times as is currently expected.
  • Economic Growth & Inflation: Consensus expectations for real U.S. GDP growth are currently 3.9% in 2022. This is still a healthy rate of growth. During the last economic cycle ending in 2020 GDP growth averaged just 2.5%. The forecast is predicated on continued strong consumer and business spending growth. Inflation has risen well beyond the Fed’s 2% average target due to a combination of both supply and demand pressures. At this time the data is inconclusive as to how much of this rise in inflation will persist into 2022 and beyond. We believe economic growth and inflation will moderate in 2022 when comparisons get more difficult and services spending increases at the sacrifice of goods. Evidence of higher wage growth penetration in higher paying industries and sectors could change our view.

Recent Trends

The Yield Curve has continued to narrow as investors brought forward the timeline of a Fed rate increase causing short-term rates to rise at a faster rate than longer term rates. We measure the yield curve by taking the difference between the 10 year Treasury yield and the 2 year Treasury yield, though other combinations of long and short maturities can be used.

While longer term rates are higher than a year ago, they remain quite low in a historical context. The yield curve acts as a market gauge for expected economic growth, and the current slope of the curve suggests more moderate growth expectations than implied in current GDP forecasts.

Source: Bloomberg

Credit Spreads remain narrow. It is hard to justify credit exposure simply based on the credit spread (the additional yield over duration equivalent Treasuries) as we’ve plumbed the lows of the last cycle. This suggests limited price gains from here (exclusive of duration exposure). There are essentially two ways to make money from a credit security – coupon income and security price changes. Just because the opportunity for price gains is more limited doesn’t mean that credit exposure is not justified, as the income component remains attractive relative to risk free bonds. That said, we believe investors should be more selective and valuation aware as we move into 2022.  

Source: Bloomberg

Absolute Yields for credit exposed securities remain historically low. And the yield advantage of below investment grade bonds over investment grade bonds has narrowed over the last year mainly due to lower yields for below investment grade bonds. Still, lower quality bonds offer an additional 2.4 percentage points in yield over higher quality bonds (as measured by the Bloomberg U.S. Corporate High Yield Index and the Bloomberg U.S. Corporate Aggregate Bond Index). If one were to simply earn the yield difference that could lead to outperformance on either a 3 or 5 year time frame. Additionally the investment grade index continues to face more interest rate risk (due to a higher duration) than the high yield index (with a much lower duration).

Source: Bloomberg


We believe the biggest investment risk in fixed income today is related to real returns. With interest rates so low and inflation expected to remain above the Fed’s 2% target for some time, investors are likely to struggle to maintain spending power through their fixed income allocation. Related to this risk is the potential for a more aggressive, hawkish Fed which could create headwinds for more economically sensitive credit securities. From an opportunity standpoint, easy inflation comparisons, easing supply chain conditions, and the potential bullwhip effect from possible over ordering and a shift in demand from goods to services could lead to lower than expected inflation readings and a less aggressive policy stance than currently expected in the marketplace.

Positioning Considerations

  • The fixed income marketplace presents a difficult backdrop of low interest rates and narrow credit spreads. Yet we need to remember that fixed income plays another role in a portfolio beyond generating income. With heightened risks of a more aggressive Fed, a profit margin squeeze from tight labor conditions, or an economy that may slow at a more rapid rate than expected, fixed income can provide ballast to a portfolio. We believe that investors should consider a more active and flexible strategy that could take advantage of mispriced sectors and rapidly changing market conditions.

  • For those investors concerned about either rising inflation or rising interest rates we suggest considering strategies that have a lower than benchmark duration and/or increased exposure to sectors with higher credit risk. Why consider credit risk? Economic expansion typically means lower defaults, which is the greatest risk for credit securities. Spreads may not narrow further, but the absolute yield looks relatively attractive. Additionally, through an active strategy one may be able to access bond categories that sit outside of the Bloomberg U.S. Aggregate benchmark that are investment grade, yet carry more attractive yields.

  • Looking around the corner. Visibility is low as we don’t know when or how aggressively the Fed’s stimulus removal will be, or at what rate of growth the economy will settle, nor do we know how this pandemic resolves itself. Here are a few considerations. Right now we believe investors are beginning to look beyond this current economic rebound boom and consider what lies beyond. Depending on whether interest rates go higher, moving out the curve would be a definite consideration – we would consider adding duration if the 10 year Treasury yield gets above a 1.7%-1.8% range. Maintaining credit exposure should continue to provide higher income and a stable price environment as long as the labor market and financial conditions remain loose. That said, there is a risk on the horizon for credit should the Fed signal a need to raise the Federal Funds rate at a pace faster than expected. We currently don’t believe this is a significant near-term risk, but this cycle is unique and should inflation continue to surprise on the upside the Fed is likely to respond more aggressively. Given how narrow spreads have become in places within the credit universe (especially below investment grade) we have begun to advocate a more selective approach and an emphasis on quality where valuations allow.

Fixed Income Indexes Characteristics

The Indexes mentioned are unmanaged statistical composites of stock market or bond market performance. Investing in an index is not possible.

Total Returns            
  december 2021 YTD 2020 2019 2018 Duration Years
Bloomberg Long Term Treasury -1.4% -4.6% 13.6% 11.0% 0.0% 18.7
Bloomberg U.S. TIPS
0.3% 6.0% 11.0% 8.4% -1.3% 7.6
Bloomberg U.S. Aggregate -0.3% -1.5% 7.5% 8.7% 0.0% 6.4
Bloomberg U.S. Agg Corporates -0.1% -1.0% 9.9% 14.5% -2.5% 8.8
Bloomberg U.S. Agg ABS -0.2% -0.3% 4.5% 4.5% 1.8% 2.1
Bloomberg U.S. Agg MBS
-0.1% -1.0% 3.9% 6.4% 1.0% 3.4
Bloomberg U.S. Agg CMBS
-0.1% -0.9% 8.1% 8.3% 0.8% 5.2
Bloomberg Municipal Bond
0.2% 1.5% 5.2% 7.5% 1.3% 4.8
Bloomberg 1-3 year Corporate
0.0% -0.1% 1.3% 2.7% 2.0% 1.8
ICE BofA Listed Preferreds
3.4% 7.7% 8.6% 18.5% -3.8% NA
Bloomberg High Yield
1.9% 5.3% 7.1% 14.3% -2.1% 3.4
S&P/LSTA Leveraged Loans
0.6% 5.2% 3.1% 8.6% 0.4% 0.0
Bloomberg Global Agg
-0.1% -4.7% 9.2% 6.8% -1.2% 7.5
Bloomberg Emerging Markets USD
1.0% -1.7% 6.5% 13.1% -2.5% 7.0

  December 2021 YTD Change bps Current Percentile 10 YR Median 10 YR Min 10 YR Max
10 year Treasury
1.5% 60 24 2.1% 0.5% 3.2%
2 year Treasury 0.7% 61 62 0.6% 0.1% 3.0%
10 year TIPS -1.1% -1 6 0.3% -1.2% 1.2%
Bloomberg U.S. Aggregate 1.8% 63 21 2.3% 1.0% 3.7%
Bloomberg U.S. Agg Corporate
2.3% 58 16 3.1% 1.7% 4.6%
 Bloomberg U.S. Agg ABS 1.1%  68 27 1.4%   0.4% 3.6% 
 Bloomberg U.S. Agg MBS 2.0%   73 19  2.6%  0.9% 3.8% 
 Bloomberg U.S. Agg CMBS 2.0%  53 19   2.4% 1.4%   3.9%
Bloomberg Municipal Bond
1.1% 4 8 2.2% 0.9% 3.5%
Bloomberg High Yield
4.2% 3 8 6.1% 3.5% 11.7%
S&P/LSTA Leveraged Loans
3.9% -10 3 4.7% 1.4% 10.1%
Bloomberg Global Agg
1.3% 49 25 1.7% 0.8% 2.4%
Bloomberg Emerging Markets USD
4.3% 81 16 5.0% 3.5% 7.9%

Option Adjusted Spreads (bps)
  December 2021 YTD Change Current Percentile 10 YR Median 10 YR Min 10 YR Max
Bloomberg U.S. Corporate Agg
92 -4 8 123 80 373
Bloomberg 1-3 year Corporate 42 7 10 68 31 390
 Bloomberg U.S. Agg ABS 38 5 20 49 22  325 
 Bloomberg U.S. Agg MBS 32 -9 46 32  132 
 Bloomberg U.S. Agg CMBS 76 -20 16 98  62  305
Bloomberg High Yield 283 -76 2 417 262 1100
S&P/LSTA Leveraged Loans 198 -177 2 350 128 994
Bloomberg Emerging Markets USD
320 40 38 312 211 720

For Index Definitions see: TouchstoneInvestments.com/insights/investment-terms-and-index-definitions
– The Fed was tightening (raising rates). Credit sold off (economically sensitive) and Interest rates moved up.
2019 – The Fed stopped tightening and then began to ease. Everything rallied, recession risk diminished and rates moved down (likely due to US/China trade war risk and foreign buying).
2020 – Pandemic. Fed in massive stimulus mode. Interest rates dropped precipitously. Credit rallied after Fed started buying junk bonds and fiscal stimulus measures appeared to be more than enough to offset economic downturn.

A Word About Risk
Investing in fixed-income securities which can experience reduced liquidity during certain market events, lose their value as interest rates rise and are subject to credit risk which is the risk of deterioration in the financial condition of an issuer and/or general economic conditions that can cause the issuer to not make timely payments of principal and interest also causing the securities to decline in value and an investor can lose principal. When interest rates rise, the price of debt securities generally falls. Longer term securities are generally more volatile. Investment grade debt securities which may be downgraded by a Nationally Recognized Statistical Rating Organization (NRSRO) to below investment grade status. U.S. government agency securities which are neither issued nor guaranteed by the U.S. Treasury and are not guaranteed against price movements due to changing interest rates. Mortgage-backed securities and asset-backed securities are subject to the risks of prepayment, defaults, changing interest rates and at times, the financial condition of the issuer. Foreign securities carry the associated risks of economic and political instability, market liquidity, currency volatility and accounting standards that differ from those of U.S. markets and may offer less protection to investors. Emerging markets securities which are more likely to experience turmoil or rapid changes in market or economic conditions than developed countries.

Performance data quoted represents past performance, which is no guarantee of future results. The investment return and principal value of an investment in the Fund will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be higher or lower than performance data given. For performance information current to the most recent month-end, visit TouchstoneInvestments.com/mutual-funds.

Please consider the investment objectives, risks, charges and expenses of the fund carefully before investing. The prospectus and the summary prospectus contain this and other information about the Fund. To obtain a prospectus or a summary prospectus, contact your financial professional or download and/or request one on the resources section or call Touchstone at 800-638-8194. Please read the prospectus and/or summary prospectus carefully before investing.

Touchstone Funds are distributed by Touchstone Securities, Inc.*
*A registered broker-dealer and member FINRA/SIPC.
Touchstone is a member of Western & Southern Financial Group

Not FDIC Insured | No Bank Guarantee | May Lose Value

crit thomas global market strategist

Richard "Crit" Thomas, CFA, CAIA

Global Market Strategist
Crit is responsible for examining and evaluating economic conditions, generating insights and providing a sharpened perspective on investment strategies for enriched portfolio construction.

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