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As advisors know all too well, 2021 will go down as a calamitous year in the fixed income space. With the Federal Reserve accelerating tapering and poised to hike interest rates, 2022 could bring more of the same for bonds.
Of course, those are broad strokes and not all corners of the bond market dithered this year. That will be the case again in 2022 and with this year drawing to a close, it's time for forecasts and outlooks, of which advisors are getting plenty.
It's not hard to find some experts waxing optimistic on bonds in 2022 and some of those good vibes are focused on corporate debt – both investment-grade and junk. An interesting call to be sure considering that both the widely followed Markit iBoxx USD Liquid High Yield Index and the Markit iBoxx USD Liquid Investment Grade Index are sporting modest year-to-date losses.
The case for corporates in 2022 is easily explained and it can be simply conveyed to clients. Although credit spreads are compressed, it's clear Treasury yields are low and the extra compensation offered by corporates is arguably too attractive to ignore.
Consider Crossovers in 2022
Working on the premise that corporate bonds will deliver for clients in the new year, advisors might want to consider crossover bonds. Crossovers are nifty class of corporate debt rated between low BBB and high BB, meaning these bonds sit right on the investment-grade/high-yield line.
Another interesting element regarding crossovers is that the group includes fallen angels – bonds born as investment-grade that were later downgraded to junk – rising stars, or junk bonds that were upgraded to investment-grade. While crossover spreads are tight, the asset class shouldn't be ignored in 2022.
“Crossover spreads have recovered to historically tight levels on the back of improving corporate earnings and balance-sheet repair made possible by business reopenings in many developed nations and rising COVID-19 vaccination rates,” according to Vanguard research. “Some relative value opportunities still exist in the crossover universe, though, supporting an investment approach like ours that uses deep fundamental analysis and nimble active management.”
Chances are most clients aren't familiar with crossovers, but that doesn't mean advisors have to reach to initiate this conversation. It's actually rather easy. In addressing clients' income concerns, advisors should note crossovers usually yield more than a typical highly-rated corporate bond. Regarding credit risk, crossovers usually have less of it than traditional junk bonds. Data support the notion that crossovers are credible long-term investments.
“Over the long term they have produced attractive risk-adjusted returns—a measure of the return earned for the amount of risk taken. From April 2006 through August 2021, the average annualized risk-adjusted return for crossovers was 2.2%, compared with 2.0% for high yield and 1.2% for BBBs, based on data from Bloomberg,” adds Vanguard.
With Crossovers, Economic Trajectory Matters
While the coronavirus bear market and recession of 2020 were unusual by the standards of traditional bear markets and recessions, at least on aspect held true to form: An elevated number of credit downgrades, leading to a spate of new fallen angels. While those bonds often underperform in weak economies, the subsequent recovery provides ballast and that's playing out again. That underscores the case for crossovers.
“And when the economy is in a recovery phase, ratings upgrades tend to be more numerous, leading to a higher proportion of BB bonds migrating to investment grade,” notes Vanguard. “These rising stars typically see their spreads tighten and prices rise more than would be the case for an upgrade within the high-yield universe, in part because of their different buyer bases.”
Translation: Now is an opportune time to consider crossovers. It's an asset class that lends itself to active management as there are limited passive options in the space. With yield and capital appreciation in the bond arena harder to come by these days, the active management/crossover combination could be compelling in 2022.