Posted by lplresearch
Tuesday, January 11, 2022
After negative returns for many fixed income sectors in 2021, the last thing fixed income investors wanted to see to start 2022 was more red, but that is unfortunately what happened. The Federal Reserve (Fed) meeting minutes were released last week and further confirmed the Fed’s recent hawkish shift and its desire to start removing monetary accommodation this year. While most of the information was known, that “some” members wanted to start to reduce the Fed’s $8.8 trillion balance sheet soon after the first rate hike surprised markets. Yields moved higher across the curve at the prospects of a quicker tightening timeline. For context, in the last tightening cycle, the Fed waited two years between the first rate hike and the beginning of balance sheet runoff.
“2022 hasn’t been the start fixed income investors were hoping for,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “But as interest rates move higher, certain fixed income sectors become more attractive and adding some interest rate risk to portfolios may be appropriate.”
U.S. Treasury yields rose sharply with the 10-year yield up 25 basis points (0.25%) last week. Most fixed income markets were negatively impacted, with the Bloomberg Aggregate index down over 1.5% for the week, matching the total return for the index for all of 2021. Moreover, long Treasury securities lost over 4% for the week, which would have been the sixth worst entire year on record for the index (going back to 1976).
Treasury inflation-protected securities (TIPS) were one of the worst performing sectors last week. TIPS were the best performing sector last year and with inflation concerns still elevated and a Consumer Price Index release expected to show one-year price increases over 7% in December, demand for TIPS should have helped buffer interest rate risks. However, inflation-protected securities were hit hard. As seen in the LPL Research Chart of the Day, last week’s -2.2% drawdown was among the worst since the taper-tantrum in 2013 (aside from the Covid-19 lockdowns in 2020).
But keep in mind that while these price moves can be painful to experience, absent defaults, they are not permanent impairments of capital. That is, unlike in equities, investors that hold bonds until maturity are guaranteed their principal back and any contractually obligated coupon payments. As for TIPS, yields are still deeply negative (-1.3% for 5-year TIPS and -0.78% for 10-year TIPS), so as the Fed contemplates exiting the Treasury and mortgage markets, we’re likely to see additional price pressures for TIPS. Moreover, with inflation expected to moderate over 2022 and with Fed rate hikes likely this year as well, we could see TIPS underperform nominal Treasury securities.
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