Capital Ideas^™ 
Investment insights from Capital Group

Rising inflation and slowing global growth are two dominant themes casting a pall over the current market environment. With increasing geopolitical uncertainty, tightening monetary policy, supply chain challenges and higher commodity prices at play, a period of global stagflation could potentially be on the horizon.

Navigating the foggy road to normal has never been more challenging, but with a long-term lens one can better understand the strong normalizing effect that disinflationary forces such as rising debt levels, technological advancements and aging demographics could have. Having a clear understanding of these can help investors better find their way.

Investing in fixed income during a time of a high inflation and rising rates can seem worrisome. However, today’s starting yields offer an attractive entry point for investors. Yields across fixed income sectors are sharply higher than their lows over the past few years. 

At current yields, history suggests higher total returns over the next few years. This means that investors could benefit from holding bonds across fixed income asset classes, including investment grade, high yield and emerging markets. This higher income can offer more of a cushion for total returns over time, even if price movements remain volatile. In fact, a greater portion of investors’ income needs could potentially be met with traditional fixed income than would have been the case in recent years

Despite current volatility, the broad credit universe provides ample opportunities for investors to add value through bottom-up research and security selection in each of the four primary credit sectors — high yield, investment grade, emerging markets and securitized debt (or debt backed by auto loans, credit card receivables or other assets). Keeping a long-term view and employing balance can help smooth the way.

Investors who seek a balanced portfolio should ensure that their fixed income allocation meets the four key roles bonds are meant to play in a portfolio.
 

1. Diversification from equities: When stocks struggle, owning bonds with a low correlation to equities can result in lower portfolio volatility.
 

2. Capital preservation: A fixed income allocation should help protect principal in most market environments, especially when rates and rate expectations have moved higher.
 

3. Income: Providing dependable income is a central function of a bond allocation.
 

4. Inflation protection: Bonds directly linked to an inflation index can help to protect an investor’s purchasing power.

Notably, investment-grade corporate bonds have become more attractive as corporate fundamentals continue to improve, with relative debt levels falling across both European and U.S. investment-grade bonds. Valuations also look attractive as global investment-grade corporate yield has increased alongside higher government bond yields and wider spreads.

U.S. high-yield fundamentals have also been improving. The credit quality of the market has improved with a higher proportion of BB-rated companies and a lower share of CCC-rated bonds, which could potentially make the market more resilient to a slowdown in growth. Defaults are currently very low, and although they may pick up should we enter a recession, we believe the yield cushion and active security selection can offset the potential risks. Yields have also become more attractive, moving from the low levels reached in 2021 to 7.5% currently. However, as volatility is expected to remain high and a higher degree of uncertainty in the economy persists, we position our credit portfolios defensively focusing on fundamentals and bottom-up research.

The emerging market debt (EMD) universe has broadened and deepened significantly in the last few decades and, as the asset class has developed, it has become more appealing to a broader investor base. Issuance has increased thereby improving liquidity. That said, rising inflation, slowing global growth, tightening U.S. monetary policy and a soaring U.S. dollar have all weighed on the sector.

The Russia-Ukraine conflict has created an additional headwind relative to other comparably rated developed market corporate debt. However, there is reason to be optimistic about the future of emerging markets. Current yield levels can provide significant cushion to further volatility.

Emerging local currency debt has been the fastest growing segment of the EMD asset class for quite some time and is now the largest part of the universe. We have a preference for local currency bonds. Compared with developed markets, EM central banks are much more advanced in their policy tightening. In addition, the increase in core inflation in emerging markets has generally been more modest than in developed markets. More aggressive rate hikes coupled with more muted inflation suggest good value in EM duration. In most of these markets hedging costs are high, so our duration exposure is primarily on an unhedged basis.

Overall EM currencies remain undervalued, but selectivity remains crucial in assessing mainly those currencies from commodity exporters countries. We still have a constructive view on commodity prices because supply shortages haven’t been alleviated. In many cases, supply issues have actually deteriorated yet global activity is still reasonable. As such there is still a structural tailwind for commodity prices.

Securitized credit can also offer a diverse array of investment opportunity across asset-backed, commercial real estate, non-agency mortgage and collateralized leveraged loan sub-sectors. Many of the fundamental drivers of these sectors are distinct from corporate and sovereign credit. This brings diversity to a portfolio.

We are currently finding good value in the single-asset single-borrower (SASB) market. These niche investments create more concentrated risks than traditional commercial mortgage-backed securities (CMBS), but the market largely consists of very high-quality properties and lends itself to deep, property-specific fundamental research. This presents an opportunity for investors to gain access to specific assets that they find attractive. This sector is under-researched by many market participants, and this enables our team of securitized credit analysts to identify numerous mispriced investment opportunities.

Uncertainty will remain in markets for the foreseeable future, and the investment environment will be challenging for investors globally. However, there will continue to be opportunities for active managers with strong research capabilities to navigate these headwinds, and allocations to fixed income assets will remain as crucial as ever.

This commentary has been republished here with permission from Global Investor Group, publisher of Global Investor magazine. Additional charts and data were added by the Capital Ideas staff.