Fixed income investors aren’t used to negative total returns for core fixed income (as measured by the Bloomberg U.S. Aggregate Bond Index) but that is exactly what happened in 2021. Last year, rising interest rates were a headwind to bond prices that more than offset the positive returns from coupon income. As such, the index was down -1.5% for the year, which was only the fourth negative returning calendar year since the index’s 1976 inception—and the first since 2013. Interestingly, 1994 was the worst year ever for the index and it was only down 2.9%. So as a reminder, a bad year in bonds is like a bad day for stocks. That said, what is likely in store for core fixed income returns in 2022?
“Core fixed income returns likely aren’t going to be great in 2022,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “However, returns are only part of the equation with bonds. Capital preservation, liquidity, and diversification benefits of core bonds still make the asset class an important one within a diversified asset allocation.
As we point out in our recent 2022 Outlook: Passing the Baton, we expect interest rates to move modestly higher in 2022 based on near-term inflation expectations above historical trends and improving growth expectations once the impact of COVID-19 recedes. Our year-end 2022 forecast for the 10-year Treasury yield is 1.75–2.00%. However, an aging global demographic that needs income, higher global debt levels, and an ongoing bull market in equities may keep interest rates from going much higher over the next year. As such, as seen in the LPL Research Chart of the Day, returns for core bond investors are likely to be muted in 2022. Fixed income investors are bound by bond math, which means starting yields are still a good estimate for future returns and with starting yields still low by historical standards, returns are likely to be low as well. In fact, if neither interest rates nor spread levels change over the course of the year, the index will return approximately its starting yield, which as of the end of 2021, was 1.75%. But, because we think interest rates could move modestly higher (and we think spreads could stay where they are or tighten marginally), core fixed income returns could be flat to slightly positive for the year—not a great year but returns could be better than 2021.
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