When Will Short Term Bond Funds Start Going Up Again

Key takeaways

• 2021 was a difficult year for bonds, but historically bond markets have rarely recorded 2 negative years in a row.
• The Federal Reserve is likely to begin raising interest rates in 2022, potentially raising bond yields and lowering bond prices.
• The Fed's actions will likely have modest impacts on most bond portfolios, but the precise extent and timing of rate hikes is uncertain.
• If you seek higher yields, professional investment managers have the research resources and investment expertise necessary to identify opportunities and manage the risks associated with higher-yielding securities.

2021 will not go down in history as a banner year for bonds. After several years in which the Bloomberg Barclays US Aggregate Bond Index delivered strong returns, the index and many mutual funds and ETFs that hold high-quality corporate bonds are likely to post negative returns for the year. But history shows that bond markets rarely string together several down years in a row and there are reasons for bond investors to feel hopeful that modestly better times are ahead in 2022.

Bond returns and interest rates (1940-2020)

Beau Coash, institutional portfolio manager with Fidelity's fixed income team, says historically, after a down year such as 2021, "A new cycle begins and rates tend to go higher over time."

That prospect of higher interest rates looks likely to be the most significant factor affecting bond markets in 2022. In the new year, the Federal Reserve intends to begin reducing its purchases of assets and to start a series of interest rate increases. The Fed's goal is to eventually raise the federal funds rate, which is the rate that banks lend to each other at and which many consumer interest rates are based on, from the current 0%-0.25% to likely as high as 1.25% by 2024. The first of these planned rate increases could come as early as July, but Fed leaders are closely watching inflation and employment data as they set interest rate policy.

Higher rates may sound good to those who primarily seek yield from their bond portfolios while sounding less appealing to those who own bonds primarily because they want prices to rise. But with the Fed planning a gradual policy of modest rate hikes, the benefits to savers may be modest and any disappointment felt by other bondholders may also be mild. As Coash puts it, "For savers, 2022 is going to be better, but not great. For borrowers, it's going to be worse, but not horrible."

This modest approach to rate hikes is unusual by historical standards. Typically, when the economy has been growing and in the mid-cycle phase of the business cycle, rates have historically been much higher than they are likely to be over the next several years. Says Coash, "Unlike in previous policy-tightening cycles, the Fed is not going to be able to raise rates significantly. In the past, the fed funds rate eventually rose to 3.5% or 4%, and 10-year Treasurys to 3.5% or 4%. That's not going to happen this time. It will be difficult for the Fed to be as hawkish as in previous recovery cycles. That's partly because of the virus's impact on service industries and potential stops and starts in the economy due to precautions and the spread of the virus."

The Fed's balancing act

While the outlook for bonds appears benign, if not very exciting, investing is never free of risk and there are several concerns in the year ahead that bond investors may want to keep an eye on. Part of the reason for the Fed's slow and low approach to raising rates is concern about avoiding actions that could trigger a recession, turn stock markets volatile, or prolong high inflation. These are significant risks and it's not impossible that the Fed could need to change policy on interest rates and asset purchases as it tries to strike a balance between slowing inflation and avoiding recession. A glance at breakeven inflation rates shows that financial markets expect inflation to gradually diminish to roughly 2.5% a year over the next several years, but the direction that inflation takes in 2022 is hardly certain.

Other factors could also affect interest rates and markets in 2022. China's economy is slowing and US growth may slow as well. The arrival of the Omicron COVID variant and the persistence of the Delta variant also raise questions about prospects for continued economic recovery.

Why bonds in 2022?

The modest expectations for bond returns in the new year do not mean bonds don't still have a meaningful role to play in investors portfolios. Bonds continue to provide ballast against potential stock market turbulence, which may increase as the economy moves into the later-middle portion of the business cycle. On the Friday after Thanksgiving, the Nasdaq fell 2%, the Russell 2000 was down 3.5% and commodities dropped 4.5%. Meanwhile, the Bloomberg Barclay's Aggregate Bond Market Index rose by 80 basis points. That example shows how a bond allocation in your portfolio can provide ballast against stock market volatility.

Naveen Malwal, institutional portfolio manager with Fidelity's Strategic Advisers LLC says that bonds also remain a compelling alternative to cash in 2022. "Even in a low-interest-rate environment, bonds can provide benefits for well-diversified portfolios. For example, from 2009 to 2020, interest rates on Treasury bonds were very low relative to history, yet bonds still outperformed short-term investments, like cash, during that time. And in most months when stock markets experienced some volatility, bonds provided positive returns."

Where to seek higher yields

The continuing low yields on high-quality bonds may tempt investors to seek higher yields from bonds with lower credit ratings or with greater sensitivity to changes in interest rates. While both of these categories of bonds may offer risks not found in high-quality corporate bonds, professionally managed fixed income strategies may help manage the risks involved with exposure to these higher-yielding bonds. As Malwal says, "In an environment where many investment-grade bonds are offering very low yields, investors may find it helpful to look to a wide variety of bonds for income and capital preservation. For instance, many of the bond managers we invest with are currently finding opportunities in high-yield bonds, floating-rate bonds, and international bonds."

Finding ideas

Maintaining a well-diversified portfolio of stocks and bonds may be as important as ever to help you reach your goals. But remember, diversification and asset allocation do not ensure a profit or guarantee against loss.

If you're considering individual bonds, be sure to do your research as the bond market is large and diverse, and getting the best prices can be tricky. If you're seeking income, make sure to consider the potential risks as well as the potential rewards of high-yield bonds.

Whatever your bond investing goals, professionally managed mutual funds or separately managed accounts can help you. You can run screens using the Mutual Fund Evaluator on Fidelity.com. Below are the results of some illustrative mutual fund screens as of December 17, 2021 (these are not recommendations of Fidelity).

Taxable bond funds

Fidelity funds

• Fidelity^® Total Bond Fund (FTBFX)
• Fidelity^® Investment Grade Bond Fund (FBNDX)

Non-Fidelity funds

• American Funds Corporate Bond Fund (BFCFX)
• MFS Corporate Bond Fund (MFBFX)

Investors can also gain exposure to bond opportunities through separately managed accounts (SMAs).

The Fidelity screeners are research tools provided to help self-directed investors evaluate these types of securities. The criteria and inputs entered are at the sole discretion of the user, and all screens or strategies with preselected criteria (including expert ones) are solely for the convenience of the user. Expert screeners are provided by independent companies not affiliated with Fidelity. Information supplied or obtained from these screeners is for informational purposes only and should not be considered investment advice or guidance, an offer of or a solicitation of an offer to buy or sell securities, or a recommendation or endorsement by Fidelity of any security or investment strategy. Fidelity does not endorse or adopt any particular investment strategy or approach to screening or evaluating stocks, preferred securities, exchange-traded products, or closed-end funds. Fidelity makes no guarantees that information supplied is accurate, complete, or timely, and does not provide any warranties regarding results obtained from its use. Determine which securities are right for you based on your investment objectives, risk tolerance, financial situation, and other individual factors, and reevaluate them on a periodic basis.

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Source: https://www.fidelity.com/learning-center/trading-investing/bond-market-2022-outlook

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