Bond markets had a difficult year in 2022 as the U.S. Federal Reserve aggressively hiked interest rates to stamp out inflation. With the end of rate increases in sight, investors may be wondering if volatility may be replaced with relative tranquility in the year ahead.
At its December meeting, the Fed moderated its approach and lifted rates by half a percentage point to a range of 4.25% to 4.50%. Investors welcomed the downshift after an unprecedented string of four 75 basis point adjustments by policymakers attempting to quash decades-high inflation. But officials underscored that they will continue to raise rates to around 5% next year.
Wide-ranging challenges still lie ahead. Among them: Inflation remains stubbornly high, and economic activity is expected to slow or contract.
Here, fixed income portfolio managers from across Capital Group weigh in about what’s next for bonds.
Even the most optimistic investors are bracing for a recession. The question is more a matter of how wide or deep the downturn will be as central banks worldwide raise rates to try to contain inflation. With growth expected to stall or contract in major economies including the United Kingdom, European Union, Japan and the United States, will high prices stick around in 2023?
Inflation remains high in most economies
Demand for sectors that quickly absorb rate increases, such as housing, has predictably declined. Other areas of the economy will take more time to cool.
“The impact of rate hikes will unfold over the next several months, likely in the form of higher unemployment, fewer job openings and declining retail sales,” says fixed income portfolio manager Ritchie Tuazon.
So far, the economy has coped surprisingly well. Ironically, bright spots could feed into the inflation problem.
“There is a flavour of stagflation ahead,” Tuazon adds. Stagflation, the much-feared mix of stagnant economic growth, high unemployment and soaring prices, warrants an active approach to bond investing. “I see select opportunities within the Treasury yield curve as well as Treasury Inflation-Protected Securities.”
“Supply chain issues appear to have worked themselves out, but the labour shortage and persistent wage growth could keep inflation higher than the Fed’s 2% target range for some time,” Tuazon says. Geopolitical risks could further undermine the Fed’s efforts.
Fixed income's role as a portfolio ballast when stocks are falling was of no help as the Fed continuously revised rate expectations upward.
It’s rare for both stocks and bonds to fall in tandem in a calendar year. In fact, 2022 marks the only time it occurred in 45 years. That’s because the Fed hiked aggressively when rates were near zero.
That should change in 2023 as inflation moderates. “Once the Fed pivots from its ultra-hawkish monetary policy stance, high-quality bonds should again offer relative stability and greater income,” according to fixed income portfolio manager Pramod Atluri.
But slowing growth and moderating inflation could be a good thing for high-quality fixed income. They should lead to lower yields and higher bond prices. Staying on the sidelines to wait out market volatility could mean giving up on income opportunities and the potential for an even higher total return. “Valuations are attractive, so I am selectively adding corporate credit,” Atluri says. “Bonds now offer a much healthier income stream, which should help offset any price declines.”
Investing six months prior to the final rate hike would have provided strong returns
As additional cracks start to show in the economy, recession fears may take centre stage. “One way or another, the consumer is going to feel more stressed in 2023. Either the economy is so strong it continues to feed into inflation, or the economy weakens and unemployment rises,” Atluri says.
Historically, investing prior to the final rate hike in a cycle would have paid off. In the last 40 years, there were six hiking cycles that offer five years of returns data. Purchasing bonds regularly for a year starting six months prior to the last Fed rate hike in each of those cycles would have returned a range of 3.3% to 10.2% in the first 12 months in U.S. dollar terms. Longer term, that year-long investment would have provided a five-year annualized total return that spanned from 5.9% to 15.6%.
Bond market losses can be painful to endure, as rising rates cause bond prices to decline. The upside is that bond yields also rise, which may set the stage for higher income down the road.
Yields have soared across asset classes
The yield on the benchmark 10-year U.S. Treasury hovered around 3.47% on December 14, 2022, versus a yield of 1.51% on December 31, 2021. Yields, which rise when bond prices fall, have soared across sectors. Over time, income should increase since the total return of a bond fund consists of price changes and interest paid, and the interest component is higher.
With investors better compensated for holding relatively stable bonds, the question of whether to invest in riskier corporate or high-yield bonds ahead of a potential recession is an important one.
Despite gloomy headlines, consumers continue to open their wallets. “This has helped keep corporate balance sheets in pretty good shape,” says Damien McCann, fixed income portfolio manager for Capital Group Multi-Sector Income FundTM (Canada).
The reward potential for corporate investment-grade bonds (BBB/Baa and higher) at current levels is enticing, but many are vulnerable in a downturn. “I expect credit quality to weaken as the economy slows. In that environment, I prefer defensive sectors such as health care over homebuilders and retail,” McCann says.
High-yield bonds are also relatively well-positioned for an economic slowdown, and their prices have declined sharply. An uptick in defaults, which the market has already priced in, could still increase in a deep recession.
“We went through a significant default cycle with the pandemic,” says fixed income portfolio manager David Daigle. “The underlying credit quality of the asset class has improved markedly since 2008. I do expect fundamentals to weaken from here so I’m positioning the funds I manage to have less exposure to consumer cyclicals such as automotive and leisure since demand for their products and services will likely soften.”
After a difficult year for bonds, there are reasons for optimism. Inflation has moderated, and Fed rate hikes are likely to peak in the not-too-distant future. Higher yields and the spectre of a recession could also send investors back into bonds in search of relative stability and income.
Today’s starting yields can offer an attractive entry point for investors and provide a cushion to further volatility. There are also compelling opportunities across asset classes that an active manager can uncover via bottom-up research and security selection.
Bloomberg U.S. Aggregate Bond Index represents the U.S. investment-grade fixed-rate bond market.
Bloomberg U.S. Corporate High Yield Index covers the universe of fixed-rate, non-investment-grade debt.
Bloomberg U.S. Corporate Investment Grade Index represents the universe of investment grade, publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity and quality requirements.
The J.P. Morgan Emerging Market Bond Index (EMBI) Global Diversified is a uniquely weighted emerging market debt benchmark that tracks total returns for U.S. dollar-denominated bonds issued by emerging market sovereign and quasi-sovereign entities. J.P. Morgan Government Bond Index — Emerging Markets (GBI-EM) Global Diversified covers the universe of regularly traded, liquid fixed-rate, domestic currency emerging market government bonds to which international investors can gain exposure. The 50%/50% J.P. Morgan EMBI Global/J.P. Morgan GBI-EM Global Diversified blends the J.P. Morgan EMBI Global Index with the J.P. Morgan GBI-EM Global Diversified Index by weighting their cumulative total returns at 50% each. This assumes the blend is rebalanced monthly.
MSCI ACWI is a free float-adjusted market capitalization-weighted index designed to measure equity market results in the global developed and emerging markets, consisting of more than 40 developed and emerging market country indexes.
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