On Global Fixed Income
Why Fixed Income Investors Should Think Differently in 2022
Higher rates and more volatility demand a flexible approach.
Arif Husain Head of International Fixed Income, Lead Portfolio Manager Dynamic Global Bond Fund
Key Insights
  • Changing dynamics mean that the past decade is probably a poor guide as to how bond markets might perform in 2022.
  • With governments and central banks simultaneously removing stimulus support, we expect a year marked by tighter global liquidity, higher interest rates, and bouts of volatility.
  • While the environment is likely to be challenging, we also see potential for great buying opportunities to emerge, so a flexible approach to bond investing will be important.

Strap yourself in: 2022 could be a roller‑coaster ride for bond investors. After more than a decade of stimulus measures, major central banks are likely to step back from supporting markets. How this evolves will matter much more than forecasts of economic data, given that aggressive central bank actions helped to drive bond yields so low in the first place. The retreat of central banks, which are typically price‑insensitive buyers, could have major implications—including tighter liquidity conditions, bouts of volatility, and higher interest rates.

The withdrawal of central bank liquidity, along with rate hikes in some countries, will come at the same time that governments wind back levels of pandemic fiscal support. The confluence of these factors is likely to drive most developed government bond yields higher. In response, bond investors may need to adopt a broader, more flexible approach that emphasizes active duration1 management.

Managing Market Challenges in 2022

Three key risks and mitigation approaches

Three key risks and mitigation approaches

As of December 31, 2021.

For illustrative purposes only. Not to be construed as a recommendation or investment advice.

Source: T. Rowe Price.

1. Key Risk—Get Ready for a Period of Tightening

Just as inflation reached unimaginable levels last year, so too may bond yields in 2022. An early hint of what might happen occurred during the autumn of 2021, when Poland’s central bank responded to inflationary pressures with three successive rate hikes in as many months. The yield on the country’s two‑year local currency bond rose by more than 250 basis points2 in just three months to end December around 3.36%.

"The path to higher rates is likely to be volatile as there is uncertainty over the pace of tightening and exactly how many central banks will join in."

The path to higher rates is likely to be volatile as there is uncertainty over the pace of tightening and exactly how many central banks will join in. For example, the European Central Bank appears reluctant to move this year, but if inflation forces its hand it could prove decisive for bond markets. Balance sheet reduction is also a possibility—the U.S. Federal Reserve, for example, has already revealed that it has held discussions about how it intends to manage this process. However, if multiple global central banks decide to shrink their balance sheets at the same time, it may have far‑reaching consequences as this type of scenario is untested in bond markets.

It’s important to remember that while the environment could be challenging ahead, at some point there’s likely to be an inflection point where valuations turn attractive and potential great buying opportunities emerge in rates markets.

Portfolio Approach—Active Duration Management Will Be Critical

We believe that managing duration actively will be critical to navigating this environment. This approach enables investors to tactically respond to different market environments and regime changes. It also gives investors flexibility and latitude to take potential advantage of any pricing anomalies and dislocations that might occur in a volatile environment.

A broad approach that brings the potential to invest in different bond markets across the globe may also be beneficial. It offers opportunities to take advantage of scenarios where policy is diverging. For example, in the current environment, we are finding potentially attractive opportunities in select emerging markets where central banks are further progressed in their hiking cycles. China’s local bonds are also appealing as the Bank of China is expected to continue easing to support growth, in stark contrast to most developed markets.3

2. Key Risk—Credit Markets Are Not Immune From Volatility

With defaults expected to remain at very low levels, the fundamental environment for credit is likely to remain strong this year. However, despite this highly supportive backdrop, it’s unlikely to be enough to save credit markets from volatility—they remain vulnerable to possible spread4 widening from broader market risks. A key market risk factor, in our view, is the prospect of liquidity support waning as central banks wind down their quantitative easing programs. The latter is likely to lead to a tightening in financial conditions, a development that may cause bouts of turbulence in risk‑sensitive markets such as credit.

Furthermore, as valuations are tight, there is less of a cushion to absorb interest rate volatility. This matters because credit contains a duration component that exposes it to changes in interest rates—a risk that is not always fully understood by investors. Over the past decade, the duration of corporate bonds has been extended, so investors may have become much more exposed to interest rate risks now than they have been in the past. Also keep in mind that duration has been a key driver of credit returns in recent years, which is not a problem when yields are trending lower. The climate is changing, though, and we may be entering a rising interest rate environment with the potential for duration losses for credit investors.

Similar to rates markets, however, at some point a potential great buying opportunity could emerge in the credit space. An example here is March 2020, when a huge sell‑off in credit opened up a good opportunity to add select exposures at cheap prices.

Portfolio Approach—Defensive Positioning and Active Duration Management

A defensive approach may work well in this environment as hedging strategies are often deployed to help navigate volatility. Managing duration actively is also critical given the duration risks to which credit portfolios may be exposed.

3. Key Risk—Stock/Bond Correlations Are Changing

Investors often assume that fixed income is a diversifying asset class that typically performs well when risk markets such as equities sell off. This has meant that government bonds have often been used as the primary source of risk mitigation to keep portfolios balanced. However, at current rates, we believe government bonds are expected to be much less effective as a diversifier than they have previously been.

Furthermore, investors should keep in mind that the stock/bond relationship is not always a constant. For much of the 1990s, for example, the correlation5 between the two was positive—we believe a return to this dynamic should not be ruled out in 2022. Markets are set to undergo significant change as monetary support is withdrawn, so it is plausible that both bonds and stocks may sell off simultaneously at times this year.

Portfolio Approach—Go Broad Using Full Toolkit of Instruments

A broad approach that deploys the full toolkit, including currency and derivatives markets, may help to balance and mitigate risks in a portfolio.

How the Dynamic Global Bond Fund May Help In This Environment

The changing market environment means that investors can no longer rely on the post‑Global Financial Crisis investment playbook and will need to think differently in 2022. We believe that the T. Rowe Price Dynamic Global Bond Fund (“the fund”) which is index agnostic and deploys active duration management, is suited to precisely this environment. Specifically, we believe our approach offers the following benefits:

Flexible: We manage duration actively within a wide latitude and have the ability to implement both long and short positions. This gives us the potential flexibility to adapt to different market cycles and environments, including rising rates. For example, when interest rates are rising, we should have the ability to cut the portfolio’s overall duration to as low as minus one year to minimize potential losses, using instruments such as fixed income futures and interest rate swaps. By contrast, when rates are falling, we can increase overall duration to as high as six years to maximize potential gains. We believe this dynamic and tactical approach to managing duration will be critical in 2022 as central banks retreat, potentially causing bond yields to rise.

"The changing market environment means that investors can no longer rely on the post‑Global Financial Crisis investment playbook...."

Broad: We benefit from a large global research platform that powers our investment ideas. Covering more than 80 countries, 40 currencies, and 15 sectors, our deep research capabilities enable us to uncover inefficiencies and exploit potential opportunities across the full fixed income investable base. Our broad approach is likely to be beneficial in 2022 as it should enable us to take advantage of scenarios where policy is diverging. Furthermore, with the potential for the stock/bond relationship to change, our ability to express views across a wide range of different currencies, bonds, and sectors should help with diversification efforts.6

Volatility Management: In pursuit of meeting our objective of high current income, our goals are to generate consistent performance, manage downside risks for our clients, and provide them with genuine diversification away from equity markets. To help achieve the latter, we implement defensive hedging positions, which may include short positions on emerging market currencies, allocations to markets displaying defensive characteristics, and/or long volatility positions via options. This gives us the potential to benefit from falls in the prices of risk assets during periods of market turbulence. As we expect volatility in 2022, our defensive approach could prove fruitful.

This year is shaping up to feature the potential risks of market volatility, higher interest rates, and tighter liquidity. Although the environment is likely to be challenging, we expect great buying opportunities to emerge at some stage in both rates and credit markets. So it’s not just a case of navigating the expected rise in volatility, but also identifying when there’s a potential inflection point. Overall, we believe this environment is conducive for our approach, which is flexible; emphasizes active duration management; and the implementation of defensive hedges to help provide diversification against risk assets.

1 Duration measures a bond’s sensitivity to changes in interest rates.

2 A basis point is 0.01 percentage point.

3 International investments can be riskier than U.S. investments due to the adverse effects of currency exchange rates, differences in market structure and liquidity, as well as specific country, regional, and economic developments. These risks are generally greater for investments in emerging markets.

4 Credit spreads measure the additional yield that investors demand for holding a bond with credit risk over a similar‑maturity, high‑quality government security.

5 Correlation measures how one asset class, style or individual group may be related to another.

6 Diversification cannot assure a profit or protect against loss in a declining market.

Important Information

Call 1‑800‑225‑5132 to request a prospectus or summary prospectus; each includes investment objectives, risks, fees, expenses, and other information you should read and consider carefully before investing.

The Dynamic Global Bond Fund is subject to the risk that rising interest rates will cause bond prices to fall. The fund is “nondiversified” so its share price can be expected to fluctuate more than that of a “diversified” fund.

Investments in foreign bonds are subject to special risks, including potentially adverse overseas political and economic developments, greater volatility, lower liquidity, and the possibility that foreign currencies will decline against the dollar. Investments in emerging markets are subject to the risk of abrupt and severe price declines. High‑yield bonds carry higher credit and liquidity risks than higher‑rated bonds, meaning there is a greater chance they will have their credit ratings downgraded or default.

The fund’s use of derivatives may expose it to additional volatility in comparison to investing directly in bonds and other debt securities. Derivatives can be illiquid and difficult to value, may involve leverage so that small changes produce disproportionate losses for the fund, and any instruments not traded on an exchange are subject to counterparty risk. The fund’s principal use of derivatives involves the risk that interest rate movements, changes in currency values and exchange rates, or the creditworthiness of an issuer will not be accurately predicted, which could significantly harm performance and impair efforts to reduce overall volatility. The fund’s attempts at hedging and taking long and short positions in currencies may not be successful and could cause the fund to lose money or fail to get the benefit of a gain on a hedged position.

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of February 2022 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

This information is not intended to reflect a current or past recommendation concerning investments, investment strategies, or account types, advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Please consider your own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.

Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only.

T. Rowe Price Investment Services, Inc.

© 2022 T. Rowe Price. All Rights Reserved. T. ROWE PRICE, INVEST WITH CONFIDENCE, and the Bighorn Sheep design are, collectively and/or apart, trademarks of T. Rowe Price Group, Inc.

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