“Even with the widening in bond markets to start 2022, health care continued to outperform broader bond indexes,” said Vanguard senior credit analyst Jamie Shin. “We believe the industry’s strong fundamentals coupled with a more benign regulatory environment across most subsectors have contributed to the relative strength. For active managers that will make security selection even more crucial going forward.”

As we look for winners and losers in 2022, we will be focusing on the following themes:

Some trends that began or accelerated during the pandemic will continue to drive the direction and pace of innovation in the industry. Pharma and biotech companies will continue to invest aggressively in emerging therapy areas like cell and gene that became more mainstream due to COVID-19 research. This will create strong demand for R&D tools and support services—some provided by life sciences and medical devices companies, others provided by health care services companies. Health care providers are another subsector to watch. After seeing the rapid adoption of telehealth and decreases in ER admissions, health care providers will be looking for ways to offer care outside of the traditional hospital setting.

We prefer companies with a track record of successfully sourcing and integrating growth assets and see some interesting opportunities in the life sciences, medical devices, and services subsectors.

While companies remain interested in finding ways to supplement organic growth and capital markets remain favorable for the sector, most management commentary from a recent industry flagship conference focused on tuck-ins and partnerships rather than transformational deals. With large M&A transactions in 2021 facing regulatory scrutiny (such as UnitedHealth’s $13 billion bid for Change Healthcare, which the U.S. Department of Justice is suing to block) and examples of profitable partnerships without a huge investment up front (such as Pfizer and BioNTech partnering to develop a COVID-19 vaccine), companies are incentivized to look for smaller deals or partnerships over megadeals.

While this is a favorable trend from a credit perspective as it reduces deal risk, we remain somewhat cautious on select pharmaceutical companies based on their historical preference for larger deals and stronger incentives to buy assets ahead of existing products’ patent expirations.

As payors also look to manage increasing costs, there will be more interest in affordable alternatives such as private label products and lower-cost-of-care settings (those outside of hospitals).

The emergence and subsequent waves of COVID-19 resulted in an unprecedented level of labor shortages in addition to cost inflation. This puts larger players with negotiating leverage and/or market density at an advantage over competitors.

Efforts to manage costs will support demand for services from health IT providers and outsourced service providers (contract research and manufacturing services for pharma and biotech, contract labor for providers).

As payors also look to manage increasing costs, there will be more interest in affordable alternatives such as private label products and lower-cost-of-care settings (those outside of hospitals).

Private equity will continue to play an important role as both buyers and sellers. In 2021, we saw a private equity consortium strike a $34 billion deal to purchase medical distributor Medline in the largest leveraged buyout since the 2008 global financial crisis. With public companies shying away from larger deals, we could see private equity doing more and bigger deals than in the past. Private equity-driven deals are likely to have higher leverage and weaker creditor protections but can be interesting opportunities to get exposure to emerging growth areas while picking up yield.

We expect higher levels of interest in health care services, given the focus on cost management, and will be looking for opportunities there while trying to avoid idiosyncratic risks such as customer concentration and excessively aggressive financial policy.

“At Vanguard, we have a global fixed income team of analysts, portfolio managers, and traders who use a bottom-up, fundamentals-based credit research process and a disciplined, collaborative approach to risk-taking,” said Sanders. “So we’re well-positioned for an investment environment like this for generating alpha through identifying securities that are likely to outperform and sidestepping those that are likely to disappoint.”

This is an abridged version of research published recently by Vanguard Fixed Income Group.