Flexibility and a collaborative multi‑sector approach, in our view, are essential components of fixed income portfolio management. These are particularly important in navigating the crosscurrents of today’s dynamic market environment. The emergence of the omicron variant of the coronavirus has unsettled markets, with sentiment shifting between alarmist and complacent since late November. At the same time, investors are still digesting the Federal Reserve’s abrupt policy shift in December from dovish to hawkish. In addition, the economy is now facing both monetary and fiscal tightening in 2022.

The simultaneous presence of these risks at a time when Treasury yields are low and credit spreads¹ are narrow by historical standards suggest that the first half of 2022 could be increasingly turbulent. Despite this cloudy backdrop, credit fundamentals are still strong and market technicals are supportive. Our flexible, active portfolio management approach should give us opportunities to take advantage of anomalies that are present in this unusual environment—as well as inefficiencies that tend to persist regardless of the macro backdrop—while managing risk in the Total Return Fund.

Odds of Fed Policy Error Increasing

In our view, the chances of a Fed policy error, such as over‑tightening policy to tame inflation, are increasing. The current environment has some parallels to the 2017–2018 period, when the market transitioned from tranquil to a higher‑volatility regime as the Fed engaged in quantitative tightening and the global growth outlook dimmed. The central bank eventually relented as markets reacted poorly to the perceived policy error.

The path of inflation—and the Fed’s response—will be a key indicator to watch in the coming months. While we acknowledge that there are still upside risks for inflation, we believe that supply chain bottlenecks and labor market tightness will gradually ease. This disinflationary dynamic would help sustain economic growth.

Outlook for Volatility in Rates and Credit

This ongoing uncertainty about the interaction of COVID‑19 trends, inflation and other economic data, and global central banks removing monetary accommodation should create volatility in rates and credit markets. We are likely to keep the portfolio defensively positioned in this environment, keeping risk exposure well balanced and toward the lower end of its historical range in the Fund. At the same time, we have been selectively adding exposure to fixed income sectors that provide relatively attractive valuations. These include some areas of securitized credit² as well as bank loans, which have floating coupons that would adjust upward as the Fed raises rates.

Relative Value Opportunities Across Sectors

A multi‑sector portfolio management approach allows the freedom for relative value comparisons across fixed income sectors. An investment‑grade corporate bond and a similarly rated municipal bond or asset‑backed security (ABS) often trade differently. To a larger extent than equity markets, fixed income markets are fragmented and tend to have investors that are narrowly focused on a sector or asset class niche. This can lead to technical pressure where some dedicated funds receiving inflows will buy because they have to put cash to work, resulting in disparate cross‑sector relative value. More diversified portfolios that employ a multi‑sector approach can capitalize on these relative value dislocations.

Along with building portfolios that diversify credit risk across sectors, we can also make tactical allocation adjustments when we identify possible relative value opportunities. These dislocations can also occur within credit sectors when our internal credit analyst teams have a meaningfully different view of the credit quality of an issuer, subsector, or industry compared with external research.

As an example, the Total Return Fund can have impactful out‑of‑benchmark allocations to high yield bonds and bank loans, where we rely heavily on the work of our high yield credit analysts. The team uses extensive proprietary fundamental research in aiming to expose and exploit value dislocations in these markets.

Flexibility to Tactically Adjust Duration

A key part of our active portfolio management approach, the flexibility to adjust duration³ in the Fund is essential in this volatile environment. At the end of 2021, overall duration was close to the benchmark with a slight bias toward a short relative duration position, in keeping with our defensive posture in the portfolio. When U.S. economic growth was still accelerating in early 2021, we maintained a meaningfully shorter‑than‑benchmark duration position, which helped dull the negative price effects of increasing yields.

Because high‑quality government debt tends to rally in periods of deteriorating risk sentiment, duration can also serve as a hedge against credit risk. Some observers have questioned the effectiveness of duration as a hedge for credit risk with Treasury yields at levels that are low by historical standards, reasoning that Treasuries have limited room to rally. We think that Treasuries will continue to be useful as a hedge against a steep sell‑off in credit and other riskier assets, such as equities. As a result, adding duration can allow investors to have more exposure to credit risk, with all else equal.

Seeking to Exploit Persistent Inefficiencies

Fixed income markets also feature some long‑lasting inefficiencies that persist despite being well understood by many market participants. Most of these inefficiencies result from imbalances between supply and demand or from investor constraints. There are also market participants with objectives other than maximizing total return, such as institutions constrained by tax considerations and those that have yield‑driven performance targets.

"Most of these inefficiencies result from imbalances between supply and demand or from investor constraints."

Our quantitative research team has identified some of these anomalies and tested their robustness in various macro scenarios. As long as we have a relatively high degree of confidence that these inefficiencies will persist in the longer term and that they are appropriate for our investor base, we try to take advantage of them. Seeking to capitalize on these inefficiencies while constructing a diversified, risk‑balanced portfolio forms the basis of our strategic asset allocation and portfolio positioning. At the same time, we are aware that there are certain transient environments where positioning to exploit these anomalies could weigh on performance, and we strive to anticipate these shorter‑term shifts and tactically adjust exposures appropriately.

Areas of Structural Inefficiency

• Shorter‑maturity investment‑grade corporate bonds historically have exhibited much higher risk‑adjusted returns than longer‑term corporates. Portfolios can hold a credit curve steepener—overweights to shorter‑duration corporate credit and underweights to longer‑duration corporates—to try to capitalize on this structural inefficiency.
• We have also observed that credit derivatives tend to perform better in credit sell‑offs than cash bonds, and it can be advantageous to replace some cash bond exposure with credit derivatives when the “basis”—the difference in spread between cash bonds and derivatives—is especially tight.
• In another example, credit quality constraints prevent some investors from holding non‑investment‑grade securities. When a bond is downgraded from investment grade into the high yield universe, forced selling from these investors can push prices lower than what the bond’s fundamentals would dictate. We try to capitalize on the relative value that can often be found in these fallen angels.
• Securitized credit is another area of structural inefficiency. Some investors were restricted from owning securitized debt after the global financial crisis, and some lack the ability to analyze the often‑complex cash flow structures of the securities. T. Rowe Price’s team of securitized credit analysts have the capability to value these bonds, allowing us to locate attractive securities and segments that other investors may overlook.

Flexible Multi‑Sector Approach

On a broader level, the income and relatively low volatility of a fixed income allocation make it an important part of a broader portfolio’s asset allocation. In the Total Return Fund, we seek to combine well‑diversified sector allocation with tactical insights to pursue strong, consistent risk‑adjusted returns across different types of market environments. Our flexible multi‑sector approach to managing the portfolio allows us to actively manage relative duration and try to take advantage of relative value among sectors.

It must be mentioned that having the platform at hand that we do at T. Rowe Price is invaluable when facing challenging market conditions. As a firm, we have tremendous expertise across the globe, reaching across the capital structure from investment-grade debt to equity, across all sectors, across macro and micro, and across fundamental and quantitative. In our view, these resources are an advantage in managing a multi‑sector fixed income portfolio when it comes to everything from navigating changing market dynamics to constructing portfolios to just plain old fundamental security selection.