Bonds

4 high-income seeking investment strategies for a high-rate world

Things are looking up for bond markets. As yields rise, the potential for income is the highest in more than two decades, and volatility tied to interest rate increases may decline as the Federal Reserve nears the end of its rate-hiking campaign. Through it all, the U.S. economy has surprised to the upside.

 

In an ideal world, achieving high income against this backdrop would be as easy as parking cash in relatively low risk money market funds and hoping it grows. The reality is more nuanced: Rates are likely to fall from here, so it’s unrealistic to expect returns from cash and cash-like investments to stay at current levels long term.

Investors have flocked to cash, driving up money market fund holdings

Sources: Capital Group, Bloomberg Index Services Ltd., Investment Company Institute (ICI). Data as of August 11, 2023. While money market funds seek to maintain a net asset value of $1.00 per share, they are not guaranteed by the Federal Deposit Insurance Corporation or any other government agency. You could lose money by investing in money market funds.

In fact, the return potential for the record $5.5 trillion sitting in money market funds will likely decline as inflation falls and the Fed concludes its rate increases. The jury is out on just how quickly or when exactly rates will fall, but bonds have historically seen returns above cash and cash-like investments in the years following a peak in the Fed funds rate.

 

Although the outlook is rosier, the economy is not out of the woods as rate increases continue to impose much higher borrowing costs on companies and consumers.

 

Against this backdrop, Damien McCann, principal investment officer for American Funds® Multi-Sector Income Fund, and David Daigle, principal investment officer for American High-Income Trust®, offer their thoughts on compelling investment opportunities as the economy and the Fed near a pivotal phase.

1. Seek to capture attractive yields before rates fall

 

Yields soared and bond prices tumbled in 2022 as elevated and persistent inflation pushed the Fed to raise rates at a breakneck pace. So far in 2023, volatility hasn’t been nearly as dramatic, but stubborn inflation has pressured the central bank to continue with more gradual rate increases.

 

More recently, the yield on the 10-year Treasury, which underpins borrowing costs for much of the economy, hit 4.35% in August, the highest level since 2007. And while the month-long volatility has been tough on bond markets, elevated long-term rates should ultimately dampen inflationary pressures.

 

Despite lingering uncertainties about the economy, one thing is clear: The rise in rates created many paths to strong income and return potential in bond markets.

 

That’s because starting yields have been a good indicator of long-term return expectations. The Bloomberg U.S. Aggregate Index, a widely used benchmark for investment-grade bonds (rated BBB/Baa and above), yielded 4.93% as of August 25, 2023. That figure is well above the index’s yield of 1.70% on December 31, 2021, prior to the start of the Fed hiking cycle. The Bloomberg U.S. Corporate High Yield Index, a broad representation of high-yield bonds, yielded 8.48% as of August 25, 2023, versus its yield of 4.41% on December 31, 2021.

Strong income potential may persist as yields stabilize at elevated levels

Sources: Bloomberg Index Services Ltd., RIMES. Data shown from July 31, 2013, to August 25, 2023. Sector yields above include U.S. aggregate represented by the Bloomberg U.S. Aggregate Index, investment-grade corporates represented by the Bloomberg U.S. Corporate Investment Grade Index, high-yield corporates represented by the Bloomberg U.S. Corporate High Yield Index and emerging markets debt represented by the 50% J.P. Morgan EMBI Global Diversified Index/50% J.P. Morgan GBI-EM Global Diversified Index blend. Past results are not predictive of results in future periods.