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Yield of dreams—what’s in store for Europe's bond markets in 2022?

Inflation is proving to be decidedly stubborn and the knock-on effects are becoming increasingly clear. The UK has already raised its rates to address the issue and bond investors are well aware that the European Central Bank (ECB) may soon follow suit.

At the end of December, the chair of the Financial Stability Board, Klaas Knot, said the ECB is preparing for a rate hike in early 2023, after winding down its pandemic bond purchases by the end of this year.

With measly coupons on higher graded paper and the economic recovery still in play, high yield will be a strategy of choice—but looming rate rises have clear implications for investors. And that means any corporates considering high yield options need to pay close attention.

Signs of maturity 

According to buysiders, to avoid getting caught out by rate hikes, short maturity credits and lower duration Bs are favoured over BBs. Picking lower rated but solid Bs and riskier CCCs could be a way to outperform this year given higher yields on offer from these lower-rated grades.

There are still concerns about what Omicron (and any future variants) could mean for COVID-19-sensitive sectors. It’s doubtful that investors will be piling into leisure issuers with gusto, for example.

But, for the most part, sub-investment grade paper with shorter maturities in industries with a solid footing will be a theme in 2022. Exposure to some dicier issuers will offer selective investors an opportunity to beat the index.

At any rate   

European high yield total returns ended 2021 with around 3% positive returns, according to BofA indices. The prospect of interest rate rises means that spreads are expected to widen in the months ahead.

Despite this, buysiders mostly see 3% positive total returns as achievable, as the receipt of coupons offsets the negative impact on total returns of any spread widening. BofA euro high yield indices in late December had a 2.9% yield, with BBs yielding around 2.2%, Bs 4.0% and CCCs 6.6%.

Lead balloons 

That said, things can always go either way. Some are optimistic that rate concerns are overbaked. Inflation is on the rise but could undershoot expectations as supply chain logjams ease, prompting the ECB to postpone any hawkish action.

Certain market contrarians have suggested that we may in fact be in store for deflation. If supply bottlenecks unblock then companies may no longer feel pressure to bulk up on what may already be overstocked inventories, with technology having an additional, secular deflationary effect.

If that counter view does play out, then bond investors will have to seriously rethink their playbooks.