2022 Midyear Market Outlook
Flexible Fixed Income
Theme Three
Arif Husain, CFA, Head of International Fixed Income and Chief Investment Officer
Sébastien Page, CFA, Head of Global Multi Asset and Chief Investment Officer
Justin Thomson, Head of International Equity and Chief Investment Officer

U.S. Treasuries and other developed sovereign bonds did an exceptionally poor job of offsetting equity volatility in the first half. This suggests that investors may need to expand their search for diversification across fixed income sectors and geographic regions.

A key question, Page says, is whether the spike in stock/bond correlations seen in early 2022 was just temporary or reflected a structural “regime change” that could keep correlations high for an extended period. If the latter explanation is correct, alternatives to the traditional 60/40 stock/bond allocation that include dynamic hedging and other defensive strategies could offer advantages to some investors.

Stock/bond correlations have switched from positive to negative several times in recent years, Page notes (Figure 4). T. Rowe Price research suggests that these shifts typically were caused by economic shocks—sudden spikes in unemployment, inflation, or interest rates.

“I think Treasuries still have a role to play in portfolio allocations—especially if the next leg of the crisis is a recession,” Page says. “But I also think investors are going to want to consider other approaches to downside risk mitigation.”

In a Rising Rate Environment, Bond Investors May Need More Diversification

(Fig. 4) Fed rate expectations vs. U.S. stock/bond correlations*

Fed rate expectations vs. U.S. stock/bond correlations*

Past performance is not a reliable indicator of future performance.

January 2006 through May 2022.

*Fed interest rate expectations = yield on two‑year Treasury note minus federal funds target rate. Actual outcomes may differ materially from expectations. U.S. stock/bond correlations = rolling two‑year correlation of monthly price changes for the S&P 500 Index and the 10‑year U.S. Treasury futures contract. Correlation measures how one asset class, style or individual group may be related to another. A perfect positive correlation means that the correlation coefficient is exactly 1. This implies that as one security moves, either up or down, the other security moves in lockstep, in the same direction. A perfect negative correlation of ‑1 means that two assets move in opposite directions, while a zero correlation implies no relationship at all.

Sources: Standard & Poor’s, J.P. Morgan North America Credit Research (see Additional Disclosures), and Bloomberg Finance L.P. Data analysis by T. Rowe Price.

A Potential Buying Opportunity?

A more immediate issue for fixed income investors is whether bond yields have reached a near‑term peak, creating a potential opportunity to lock in portfolio income.

“In our view, this is the most attractive point to buy bonds that we’ve seen for several years,” Husain says. “We think that over the next several quarters investors may want to consider adding duration.”1

However, Husain also predicts that the Fed will continue tightening until it has pushed its key market rate, the federal funds rate, into positive territory in after‑inflation terms. With the nominal fed funds rate still under 1% at the end of May, that would seem to leave considerable room for further rate hikes. As of early June, he adds, “I don’t think we’re quite at the peak for yields.”

For U.S.‑based investors worried about rising rates, global markets could offer diversification potential, Husain suggests. While the Fed is tightening, other countries are further along in their interest rate cycles. Some have stopped raising rates. Others have even started cutting them.

“By taking advantage of monetary policy divergence, investors can seek to diversify their interest rate exposures on a currency‑hedged basis,” Husain explains. Recent valuation levels potentially make emerging markets (EM) U.S. dollar bonds particularly attractive, he adds, although both country selection and underlying security selection will be critical.

The Upside Potential of Higher Yields

If yields do continue to rise, Husain says, at some point they should reach levels that offer attractive income opportunities for investors who understand how to manage duration— or who can rely on skilled investment professionals to do it for them. “Over the medium term, I think yields will reach levels that will make clients happy with the income they’re getting from their bond portfolios,” he says.

"Over the medium term, I think yields will reach levels that will make clients happy with the income they’re getting from their bond portfolios."
— Arif Husain, CFA, Head of International Fixed Income and Chief Investment Officer

Some credit sectors, such as high yield corporate bonds, may have reached that point, Husain suggests. “Looking at the high yield universe, I’ve seen yields in the 7% to 8% range, in some cases,” he says. “I’ve seen some BB rated bonds priced at 80 cents on the dollar. Those are levels that historically have proven to be good buying points.”

The caveat to the bullish case for high yield is the uncertain economic outlook, Husain notes. As of May, high yield default rates remained near historical lows, and rating upgrades were more than twice as high as downgrades. But a growth shock could quickly change that picture.

“The threat of recession is real,” Husain cautions. “So investors need to do their homework.” For T. Rowe Price fixed income portfolio managers, he adds, this will mean relying on the firm’s extensive research capabilities and independent credit ratings to help navigate risks.

In volatile markets, duration management and yield curve positioning also could be important tools for managing risk, Husain suggests. “Fixed income is a relatively liquid asset class, so I would argue that investors could potentially benefit by using that liquidity to stay active,” he says.


For illustrative purposes only. This is not intended to be investment advice or a recommendation to take any particular investment action.

1 Duration is a measure of exposure to interest rate risk that takes into account both a bond’s maturity and the timing of any coupon payments. The higher a bond’s duration, the more its value will fall as interest rates rise.

Additional Disclosures

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Important Information

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 June 2022 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

Risks: 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. Small‑cap stocks have generally been more volatile in price than the large‑cap stocks. The value approach to investing carries the risk that the market will not recognize a security’s intrinsic value for a long time or that a stock judged to be undervalued may actually be appropriately priced. Sustainable investing may not succeed in generating a positive environmental and/or social impact. Fixed‑income securities are subject to credit risk, liquidity risk, call risk, and interest‑rate risk. As interest rates rise, bond prices generally fall. Investments in high‑yield bonds involve greater risk of price volatility, illiquidity, and default than higher‑rated debt securities. In periods of no or low inflation, other types of bonds, such as US Treasury Bonds, may perform better than Treasury Inflation Protected Securities. Investments in bank loans may at times become difficult to value and highly illiquid; they are subject to credit risk such as nonpayment of principal or interest, and risks of bankruptcy and insolvency. Diversification cannot assure a profit or protect against loss in a declining market. Derivatives may be riskier or more volatile than other types of investments because they are generally more sensitive to changes in market or economic conditions; risks include currency risk, leverage risk, liquidity risk, index risk, pricing risk, and counterparty risk.

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.

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