Fixed income: Turn to nontraditional sectors for greater return potential in 2022

As discussed in our 2022 credit sector outlook piece, Break with tradition in 2022, we see opportunities in a few nontraditional credit sectors that stand out to us as having a higher probability of generating excess returns in the months ahead (Figure 1):

• Emerging markets (EM) high-yield sovereign debt looks attractive because it is one of the few sectors whose credit spreads have been trading wide to their historical median. Although many EM countries’ fundamentals have deteriorated somewhat as a result of increased debt burdens amid the COVID crisis, global institutional support has been forthcoming from the likes of the IMF and World Bank. While we do expect some idiosyncratic EM debt defaults (as always), we believe a carefully assembled basket of high-conviction issuers should serve investors well over the medium term.
• Despite concerns around lofty equity valuations, convertible bonds exhibit a trait that many other fixed income assets lack these days: positive convexity. Sectors like high-yield bank loans may have limited upside due to tight credit spreads, along with all the accompanying credit downside risk. Equities, by contrast, can continue to appreciate in a mid- to late-cycle economic scenario, while the convertibles themselves retain a bond “floor,” helping to mitigate potential losses. We also like converts because they offer diversifying opportunities that may not be available in other bond sectors.
• Non-agency residential mortgage-backed securities (RMBS) still appeal to us. This sector’s fundamentals should benefit from the ongoing strength of the US housing market, which continues to be buoyed by low mortgage rates and scant supply.

Figure 1

Manage risk but stay nimble

Reductions in fixed income portfolio risk may be warranted in the months ahead, especially if valuations remain tight or compress further. However, we also think investors should remain nimble if, for example, bouts of increased volatility lead to greater idiosyncratic dispersions or inefficiencies across fixed income markets.

In this still-uncertain market environment, a “barbelled” approach, consisting of larger allocations to higher-quality, liquid assets like cash and developed market government bonds, may make sense. For greater return potential, where appropriate, leaning further into those select, nontraditional sectors highlighted above may be an effective strategy in 2022.

Learn more

Please read our full 2022 credit sector outlook piece, Break with tradition in 2022, for a deeper dive. And for related content, be sure to check out A credit strategy designed for all seasons, authored by several of our fixed income and multi-asset colleagues.