Investment Review and Outlook

Fed Advances Taper Schedule, Sets the Table for Long-Anticipated Rate Increases.

Midway through 4Q, the Fed had a plan in place to complete tapering bond purchases by June 2022. By the end of the quarter, the plan was accelerated to end in March 2022, as the Federal Open Market Committee (FOMC) grew more concerned about inflationary trends.¹

While interest rates are still low, Fed policy is turning less accommodative with tapering and rate hikes expected in 2022. At its last meeting of the year in December, 12 out of 18 FOMC members were on record as expecting at least three rate raises this year, up from September’s forecast where half of the Fed members saw at least one hike in 2022.²

The Fed raised its inflation expectation for 2022 and lowered its gross domestic product (GDP) expectations.³ Still, U.S. GDP growth should be healthy over the next year, with low unemployment and strong wage gains. S&P 500 earnings are projected to grow by 40 percent in 2021, decelerating to about 9 percent in 2022.⁴

As the quarter progressed, corporate bond issuance slowed. IG new supply moderated in 4Q and was well absorbed.⁵ IG fund flows slowed markedly in 4Q but were healthy for the full year.⁶

A strong majority of U.S. IG rating agency actions in 2021 were positive.⁷ Actions may be more balanced in 2022. Leverage declined steadily during 2021, as cash flows rebounded.⁸ The pace of deleveraging may slow next year.

Trends in corporate actions that can be considered credit negatives: stock buybacks, increasing shareholder dividends, and merger and acquisitions (M&A)—all actions that were restrained during the pandemic—showed some signs of increasing, as 2021 closed.⁹

Specifically, M&A bounced back in 2021. As reported by Reuters, “Overall deal volumes in the United States nearly doubled to $2.61 trillion in 2021, according to Dealogic.”¹⁰ High cash balances suggest M&A should remain elevated in 2022.

Corporate spreads ended the year about 15bps off their tights from the summer offering a potential better entry point. Stable fundamentals suggest range-bound spreads and corporates offer value relative to other IG asset classes.

For the quarter, the total return for the Bloomberg U.S. IG Corporate Bonds Index was 0.23 percent and excess return versus duration-matched Treasuries was negative 0.29 percent.¹¹

Fundamentals

Strong Earnings, More Upgrades and Fewer Downgrades

We view fundamentals as modest strengths for the IG market headed into 2022.

Reflecting improved credit metrics, U.S. IG rating agency upgrades were about two-thirds of total actions in 2021 (See Figure 1).

Earnings growth and credit upgrades both peaked in 2Q21. Rating actions may be more balanced in 2022.

Leverage declined steadily during 2021, as cash flow rebounded. The pace of deleveraging may slow next year.

S&P 500 earnings are projected to grow by over 40 percent in 2021, decelerating to about 9 percent in 2022. Supply chain, labor, and wage pressure are ESG risks that are expected to persist into 2022. Tense U.S. and Russia foreign relations and China’s economic imbalances and military buildup are additional risks. Finally, regulations in some sectors may shift and corporate taxes may rise.

M&A and Shareholder Enhancements Sped up in 2021

The value of M&A, share buybacks and dividends all accelerated in the second half of 2021.

As earnings growth slows next year, and assuming rates stay low in a historical context, conditions for M&A appear ripe.

With stronger balance sheets and robust liquidity, shareholder enhancements should also continue to grow in 2022.

We view potential event risk next year as a modest weakness and a partial offset to the credit repair that occurred in 2021.

Technicals

IG Supply and Demand Indicators Both Slowed in 4Q

We see technicals as a neutral influence for the IG market entering the new year. IG fund flows slowed in 4Q but were healthy for the full year. IG new supply was moderate in Q4 and well absorbed.

IG fixed-rate supply of $319 billion in 4Q was the lowest quarterly tally for 2021, although it was up 20 percent year-over-year (Y/Y).

Net supply of $84 billion in 4Q was modest due to redemptions.

IG supply of $1.7 trillion in 2021 was the second highest yearly total ever, albeit down from $2.1 trillion in 2020.

Net issuance (gross supply minus redemptions) was $561 billion in 2021.¹²

IG fund flows of $15 billion in 4Q was 86 percent lower (Y/Y). On a year-to-date (YTD)-basis, flows were $324 billion. Foreign inflows of $110 billion for 2021 ran at about two-thirds the pace of the prior year.¹³

IG corporate primary issuance continued to see oversubscriptions with deals typically pricing through IPT, suggesting healthy order books relative to deal size and excess investor demand. We expect supply and fund flows to both slowing modestly on higher interest rates in 2022.

Valuations

IG Corporate Spreads Finish 2021 Marginally Tighter

Our view on valuations is neutral, an improvement over the modest weakness they represented in our view entering 4Q.

At 92bps, the IG Corporate Index OAS was 4bps tighter in 2021 and traded in a narrow range of 21bps from peak-to-trough.

Spreads on corporate bonds with maturities ranging from 1- to 3-years were 10bps wider, while spreads for 10+-year bonds were 5bps tighter in 2021, creating buying opportunities at the short-end.

Corporate bonds rated AAA, AA, and A, widened by 6bps, 5bps, and 7bps, respectively, and BBB-rated bonds widened by 10bps in 4Q.¹⁴ BBB-rated bonds offer selective value across the curve, but quality spreads are still tight and credit picking is crucial.

Stable fundamentals and neutral technicals suggest rangebound spreads, but we expect some volatility related to Fed hikes as we look out into 2022.

ESG Spotlight

The COP26 global climate conference, efforts of non-governmental organizations to bring greater consistency to ESG reporting, and initiatives related to reporting requirements related to human capital issues kept the focus on material ESG factors during 4Q.

While the Glasgow Climate Pact agreed to at COP26 included new commitments to reduce greenhouse gas emissions, most agree more must be done and quickly. Our Chief Investment Officer Oggie Sosa shared his views on the COP26 outcomes in our recent ESG Newsletter. His commentary is here.

Globally, efforts to increase, codify, and bring consistency to ESG disclosures advanced during 2021. Director, ESG Research Rob Fernandez, CFA, reviewed developments in this article.

Several members of the corporate bond research team shared their thoughts on recent legislative and regulatory initiatives related to ESG issues, with particular attention to human capital issues, in this article. 

As the year closed, issuance of green, social, sustainable, or sustainability-linked bonds to finance ESG-related progress reached a new record.¹⁵ The increase matched strong demand from investors for ESG debt addressing climate risks, social concerns such as inequality or health equity, and corporate governance issues. Market observers expect demand for and issuance of bonds to finance progress on addressing ESG risks to continue in the new year.

[1] Minutes of the Federal Open Market Committee, December 14-15, 2021.

[2] Federal Reserve Issues FOMC Statement, December 15, 2021.

[3] Ibid.

[4] FactSet Earnings Insight, December 17, 2021.

[5] Barclays Research, US Investment Grade Corporate Update, January 3, 2022.

[6] Wells Fargo Securities, EPFR/Informa Business, January 3, 2022.

[7] Moody’s, S&P and Fitch rating actions, US Investment Grade Corporate Issuers, December 31, 2021.

[8] Bloomberg Intelligence, Investment-Grade Fundamentals: 3Q21, November 23, 2021.

[9] Yardeni Research Inc, Corporate Finance Briefing, December 21, 2021.

[10] Reuters, Global M&A Activity Smashes All-Time Records to top $5 Trillion in 2021, December 20, 2021.

[11] Bloomberg US Corporate Bond Index, December 31, 2021.

[12] Barclays Research, US Investment Grade Corporate Update, January 3, 2022.

[13] Wells Fargo Securities, EPFR/Informa Business, January 3, 2022.

[14] Barclays Research, US Investment Grade Corporate Update, January 3, 2022.

[15] Reuters, Global Sustainable Bonds See Record Issuance in Jan-Sept 2021, October 12, 2021.

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