
Shifting Dynamics in Taxable Fixed Income
Key Points
- The Fed changed course and is projected to increase rates 4 times in 2022
- Short-term rates are moving up more quickly than long-term rates
- Floating rate sectors of high yield are poised to outperform
Treasury rates were volatile over the fourth quarter, but, on balance, long rates were stable. High-quality taxable bonds moved higher by just 0.01% 1. Fixed income credit valuations spent most of 2021 at historical highs, but risk repriced and became more attractive by the end of the quarter, reflecting the impact of the Omicron variant and a shift in policy normalization pace from the Fed. Rate liftoff was expected in late 2022, but the Fed has now shifted to 4 hikes as a base case.
On the U.S. Treasury front, 2-year, 3-year and 5-year notes moved up 0.49%, 0.43% and 0.30%, respectively, while the 10-year note remained unchanged and the 30- year note dropped 0.15% 2. This phenomenon is called curve flattening and tends to occur as the Fed increases short-term interest rates. Despite the stability in long rates, we expect the 10-year note to be within 2-2.5% by year-end. Higher short-term rates are positive for investors in conservative strategies, and our projected rate increases will not erode returns in high-quality fixed income strategies. We forecast returns in high-quality fixed income of 1.0% and recommend an overweight to high yield.
With high inflation and imminent Fed hikes, the landscape is changing within opportunistic income. We expect returns to fall slightly from 2021 levels, but are still projecting a 3-5% return range. As short rates rise, floating rate asset classes like leveraged loans and structured credit are the likely outperformers. Emerging Market High Yield will experience a bumpy ride in 2022. Now that policy accommodation is waning, the dollar could move higher, putting pressure on Emerging Market balance sheets. From its lows in May, the dollar has moved up 6.82%³ and, while stable in 2022, U.S.-based short term rates are significantly higher than global rates, which will cause cross-border flows into U.S. assets.
Volatility in rates and credit will create significant opportunity within taxable fixed income. We recommend utilizing episodes of weakness to reallocate into floating rate sectors of the high yield market.
1 LBUSTRUU Index: Bloomberg Barclays US Aggregate Bond Index
2 GT2 Govt, GT3 Govt, GT5 Govt, GT10 Govt, GT30 Govt: US Government Treasury Bonds
3 DXY Index: The U.S. Dollar Index
T Curve: a curve that shows the interest rate associated with different contract lengths for a particular debt instrument (e.g., a treasury bill). It summarizes the relationship between the term (time to maturity) of the debt and the interest rate (yield) associated with that term.
Important Disclosures
Important Information
Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as of the date of this document and are subject to change.
The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell any of the securities mentioned herein.
Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements, which do not re-flect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources and, although believed to be reliable, it has not been independently verified and its accuracy or completeness cannot be guaranteed.
Concentrating assets in a particular industry, sector of the economy, or markets may increase volatility because the investment will be more susceptible to the impact of market, economic, regulatory, and other factors affecting that industry or sector compared with a more broadly diversified asset allocation.
Private investments often engage in leveraging and other speculative investment practices that may increase the risk of investment loss, can be highly illiquid, are not required to provide periodic pricing or valuation information to investors, and may involve complex tax structures and delays in distributing important tax information.
Alternative investments are speculative, entail substantial risks, offer limited or no liquidity, and are not suitable for all investors. These investments have limited transparency to the funds’ investments and may involve leverage which magnifies both losses and gains, including the risk of loss of the entire investment. Alternative investments have varying and lengthy lockup provisions. Please see the Offering Memorandum for more complete information regarding the Fund’s investment objectives, risks, fees, and other ex-penses.
Investments in below-investment-grade debt securities, which are usually called “high-yield” or “junk bonds,” are typically in weaker financial health and such securities can be harder to value and sell and their prices can be more volatile than more highly rated securi-ties. While these securities generally have higher rates of interest, they also involve greater risk of default than do securities of a high-er-quality rating.
There are inherent risks with equity investing. These risks include, but are not limited to, stock market, manager, or investment style. Stock markets tend to move in cycles, with periods of rising prices and periods of falling prices. Investing in international markets carries risks such as currency fluctuation, regulatory risks, and economic and political instability. Emerging markets involve height-ened risks related to the same factors, as well as increased volatility, lower trading volume, and less liquidity. Emerging markets can have greater custodial and operational risks and less developed legal and accounting systems than developed markets.
There are inherent risks with fixed-income investing. These risks may include interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond. When interest rates rise, bond prices fall. This risk is heightened with investments in longer-duration fixed-income securities and during periods when prevailing interest rates are low or negative. The yields and market values of munici-pal securities may be more affected by changes in tax rates and policies than similar income-bearing taxable securities. Certain inves-tors’ incomes may be subject to the Federal Alternative Minimum Tax (AMT), and taxable gains are also possible. Investments in be-low-investment-grade debt securities, which are usually called “high yield” or “junk bonds,” are typically in weaker financial health and such securities can be harder to value and sell, and their prices can be more volatile than more highly rated securities. While these securities generally have higher rates of interest, they also involve greater risk of default than do securities of a higher-quality rating.
All investing is subject to risk, including the possible loss of the money you invest. As with any investment strategy, there is no guar-antee that investment objectives will be met and investors may lose money. Diversification does not ensure a profit or protect against a loss in a declining market. Past performance is no guarantee of future performance.
Indices are unmanaged and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses.
Alternative investments are speculative, entail substantial risks, offer limited or no liquidity and are not suitable for all investors. These investments have limited transparency to the funds’ investments and may involve leverage which magnifies both losses and gains, including the risk of loss of the entire investment. Alternative investments have varying, and lengthy lockup provisions.
This material is available to advisory and sub-advised clients, as well as financial professionals working with City National Rochdale, a registered investment advisor and a wholly-owned subsidiary of City National Bank. City National Bank provides investment man-agement services through its sub-advisory relationship with City National Rochdale.
Index Definitions
S&P 500 Index: The S&P 500 Index, or Standard & Poor’s 500 Index, is a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S. It is not an exact list of the top 500 U.S. companies by market cap because there are other criteria that the index includes.
Bloomberg Barclays US Aggregate Bond Index (LBUSTRUU): The Bloomberg Aggregate Bond Index or “the Agg” is a broad-based fixed-income index used by bond traders and the managers of mutual funds and exchange-traded funds (ETFs) as a benchmark to measure their relative performance.
GT2 Govt, GT3 Govt, GT5 Govt, GT10 Govt, GT30 Govt: US Government Treasury Yields
DXY Index: The U.S. dollar index (USDX) is a measure of the value of the U.S. dollar relative to the value of a basket of currencies of the majority of the U.S.’s most significant trading partners.
Dow Jones U.S. Select Dividend Index DJDVP: The Dow Jones U.S. Select Dividend Index looks to target 100 dividend-paying stocks screened for factors that include the dividend growth rate, the dividend payout ratio, and the trading volume. The components are then weighted by the dividend yield.
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