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Bonds
Bond outlook: End of historic Fed hikes ushers in optimism
Oliver Edmonds
Fixed Income Portfolio Manager
Tom Chow
Fixed Income Portfolio Manager
Kirstie Spence
Fixed Income Portfolio Manager
Vikas Malhotra
Fixed Income Portfolio Manager
KEY TAKEAWAYS
  • The Fed has indicated they are done raising interest rates, which has historically been a good time to own bonds
  • Rate cuts could happen in 2024 if inflation falls closer to target and the economy slows
  • Yields are near 20-year highs across credit sectors, offering higher income potential

Falling inflation alongside a cooling economy has bond investors feeling relieved: The Federal Reserve may finally be done lifting interest rates. And with yields across bond markets near 20-year highs, bonds could be the comeback story of 2024.


Investors have been here before — only for the central bank to continue to raise rates as inflation didn’t slow quickly enough. “The difference this time compared to the past year is a combination of inflation falling much closer to target and many more data points showing that high interest rates are taking a toll on the economy,” says Oliver Edmonds, portfolio manager for CGCB — Capital Group Core Bond ETF and American Funds Mortgage Fund®.


Fed hikes have lifted yields across bond sectors

The bar chart above shows the latest yield as a percentage of the 20-year range for the following bond sectors: global aggregate, U.S. investment grade, U.S. high yield and emerging markets. Alongside the percentile range to the right is the yield for each of the sectors as of November 30, 2023. For global aggregate, the yield as of November 30, 2023, was 3.93%, which is in the 86th percentile. For mortgage-backed securities, the yield as of November 30, 2023, was 5.26%, which is in the 84th percentile. For U.S. investment grade, the yield as of November 30, 2023, was 5.60%, which is in the 83rd percentile. For U.S. high yield, the yield as of November 30, 2023, was 8.43%, which is in the 75th percentile. For emerging markets debt, the yield as of November 30, 2023, was 8.52%, which is in the 92nd percentile.

Sources: Capital Group, Bloomberg Index Services Ltd., J.P. Morgan. Indexes used are the Bloomberg Global Aggregate (global aggregate), Bloomberg U.S. MBS: Agency Fixed Rate MBS Index (U.S. mortgage-backed securities), Bloomberg U.S. Corporate Investment Grade Index (U.S. investment grade), Bloomberg U.S. High Yield 2% Issuer Cap Index (U.S. high yield) and the J.P. Morgan EMBI Global Diversified Index (emerging markets). As of November 30, 2023.

The Fed has kept rates steady for several months after raising them since March 2022 to the current range of 5.25% to 5.50%. Officials signaled three rate cuts and intend to lower borrowing costs to 4.6% by the end of 2024.


Meanwhile, employment and consumer spending have remained surprisingly resilient. The unemployment rate hovered at 3.7% in November, with 199,000 jobs added. That rate is above the 50-year low of 3.4% that the U.S. hit in April 2023.


“The lifeblood of the economy is the consumer, who is supported by full employment. Once you see employment figures declining past a certain point,” Edmonds adds, “it can easily spiral, and you can end up in a situation where the Fed has overtightened.”


That point — according to one recession indicator known as the Sahm rule — is when the three-month unemployment average is 0.5% point or more above its low in the prior 12 months. The current value is 0.3% point.


A positive outlook on interest rates


When the Treasury yield curve inverted — meaning short-term yields moved higher than long-term yields — in July 2022, many viewed it as an alarm bell for an imminent recession. More than a year on, a recession has not materialized, but it is still too early to tell whether the Fed managed to pull off a “soft landing,” believes Tim Ng, portfolio manager for American Funds® Strategic Bond Fund.


Historically, the average time frame for a recession following an inverted yield curve has been about 15 months, with the longest interval being 24 months. Moreover, the Fed’s rate hikes will continue to be felt as they filter through the economy. In response to the uncertainty, bond markets have seesawed between the belief that the Fed will keep rates higher for an extended period and they will cut interest rates in 2024 to avoid deep economic damage.


Under both scenarios, investors may want to position for a normalization or steepening of the yield curve, where long-term Treasury yields are higher than short-term yields, says Ng, a member of Capital Group’s U.S. rates team. “The yield curve is likely to steepen in a recessionary environment and could also steepen in a higher-for-longer environment where short-term yields remain anchored while longer term yields rise.”


The inverted yield curve has started to normalize

The image is a line graph showing the difference between 10-year and two-year U.S. Treasury yields (basis points) between 1981 and November 2023. Recessions are represented by grey columns and values below zero (inverted yield curves) are represented by magenta dots. Historically, the graph shows that two-year Treasury bonds have been higher than 10-year bonds, while each recessionary period over this time frame has been preceded by an inverted yield curve. The yield curve was negative in April 1981, January 1989, February 2000, December 2005, August 2019, and July 2022.

Sources: Capital Group, Bloomberg Index Services Ltd., National Bureau of Economic Research, Refinitiv Datastream. As of November 30, 2023.

Current valuations may offer an attractive entry point as the interest rate outlook is more benign. “Further curve inversion is likely limited and would require a reacceleration of inflation, which we consider a low probability,” Ng adds.


Prices have declined for several categories in the Consumer Price Index (a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services), including used cars and trucks, hotels and airfares. Meanwhile, fewer categories have outsized price increases. These trends should continue, while further loosening in labor markets may lead to a sustained cooling in wage growth. The Fed could feel less pressure to keep rates high and may lower its policy rate if it is perceived to be too restrictive given the level of inflation.


The point in the cycle when the Fed is done hiking rates has tended to be an attractive time to own duration, which measures a bond’s sensitivity to interest rates, and is a hallmark of bonds with longer maturities. “If you study the end of rates cycles in the U.S., these periods have been generally positive for fixed income and for duration,” Ng says.


Mortgages and investment-grade bonds offer compelling opportunities


Despite an uncertain economic outlook, high starting yields combined with a confluence of supportive factors currently underpin agency mortgage-backed securities (MBS) and investment-grade corporate bonds (rated BBB/Baa and above).


Over the past few years, there were periods when valuations for higher coupon mortgages were especially attractive, according to Edmonds. Most notably, the regional bank crisis early in 2023 caused yield spreads over Treasuries to dramatically widen before ultimately narrowing as it became clear the economy could withstand the shock of the crisis.


“The narrative for mortgages flipped from being unattractive to being attractive fairly quickly, so it’s about seizing opportunities as they arise,” Edmonds says.


Looking into 2024, the impact of a continued runoff of the Fed’s balance sheet may become a more prominent topic, as the central bank has been price insensitive and the largest buyer of mortgage securities over the last few years. Nevertheless, housing inventory and affordability remain near all-time lows, which will continue to reduce the supply of mortgage securities and, in turn, support valuations.


“As securities that carry an implicit government guarantee, agency MBS can be an outstanding way of adding income to a portfolio without taking credit risk that correlates with equities and other assets,” says David Betanzos, a portfolio manager for The Bond Fund of America®.


Meanwhile, investment-grade corporate bonds are supported by strong balance sheets and low refinancing needs. In a modest growth environment, investors could earn the coupon payment without too much downside risk. If the economy slows and Treasury yields decline, the sector’s longer duration relative to other credit sectors such as high yield would mean potential price appreciation, which could offset any widening in spreads.


Overall, investment-grade corporate bonds can provide a solid middle ground for portfolios. If the Fed executes a ”soft landing“ and avoids a recession, investment-grade credit should fare well. And if there’s a recession, the drawdown, or peak-to-trough decline in returns, should be muted compared to what would be expected in other areas of credit, especially lower rated bonds.


Many investment-grade-rated companies won't face pressure to issue new debt until interest rates come down as they used the pandemic era’s low interest rate environment to lock in financing at attractive rates with long maturities. Therefore, supply will likely remain muted even as demand from investors such as pension funds, banks and insurance companies continues.


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Healthy income potential in high yield


Amid the fuss about where rates are going, you could have easily missed the healthy returns that high-yield bonds posted in 2023. The lesson: High-yield bonds (rated BB/Ba and below) can offer powerful income potential.


Despite the risk of a decline in earnings growth and lower cash flows for many companies in 2024 — especially those with leveraged balance sheets — high-yield bonds have historically done well as long as economic growth remains positive. Even if spreads to Treasuries widen, with yields around 8.4%, the income component can be significant and result in positive returns.


The refinancing needs of many companies rated high yield have caught the attention of markets, but most don’t hit a “maturity wall” until 2026, says Tom Chow, portfolio manager for American High-Income Trust®. Moreover, the overall credit profile of the high-yield sector has improved as companies with significant leverage have turned to private credit for funding.


“Investors have priced in an uptick in default rates to be in the 4% to 5% range in 2024,” explains Chow. “It really is about credit selection,” he adds, noting technology companies with high recurring revenues and large equity cushions are attractive in this environment. Chow is more selective about issuers rated CCC-and-below.


A balanced approach to emerging markets debt


Emerging market (EM) local currency bonds are less vulnerable to higher developed market rates than previously. Many EM economies have seen improving economic trends. “On balance, the fiscal deficits of several EM countries have narrowed to or below pre-pandemic levels,” says Kirstie Spence, portfolio manager for American Funds Emerging Markets Bond Fund®. Meanwhile, as inflation has been declining, EM central banks are starting to cut interest rates. Falling EM rates alongside decent fundamentals should support EM local currency bonds in 2024.


The hard currency, U.S. dollar-denominated bond market is divided between issuers rated investment-grade and high yield. Spreads on some higher yielding, lower credit quality EM bonds have trended wider, but are being driven by factors specific to each credit, requiring case-by-case analysis. Many investment-grade credits offer lower income but are supported by relatively strong fundamentals.


Spence favors a balanced approach to owning both hard and local currency issuers: A blended portfolio can benefit from the differentiated risk profiles and return drivers for each segment of the market. Historically, two-year forward returns have been positive when yields reached 6.7% or higher. High starting yields offer a buffer against any volatility that the global macroeconomic and geopolitical environment might bring in 2024.


Municipal bond fundamentals appear solid in uncertain environment


Rising yields have dampened municipal bond returns over the past few years. The silver lining? Solid income opportunity. The Bloomberg Municipal Bond Index (“Muni Index”) yielded 3.6% as of November 30, 2023. Investors can often also benefit from munis’ tax-exempt status. That advantage over taxable bonds starts at federal tax rates as low as 29%.


Muni income could surpass taxable bonds even at some lower tax brackets

The bar chart above shows the tax-equivalent yield for core muni bonds, as represented by the Bloomberg Municipal Bond Index for three tax rates: no impact, 29% federal tax rate and 40.8%, which is the highest federal tax rate. With no tax impact, the yield is 3.6%, with a 29% federal tax rate the yield is 5.1% and with a 40.8% federal tax rate the yield is 6.0%. A horizontal dotted magenta line indicates that the core taxable yield of the Bloomberg U.S. Aggregate Bond Index of 5.1%.

Sources: Capital Group, Bloomberg Index Services Ltd. As of November 30, 2023. The after-tax (or tax-equivalent) yield of a municipal bond investment is the yield a taxable bond would have to offer to equal the same amount as the tax-exempt bond. Highest tax rate assumes the 3.8% Medicare tax and the top federal marginal tax rate for 2023 of 37%, for a total federal tax rate of 40.8%.

Robust state coffers suggest strong fundamentals. Corporate income and general sales tax receipts continue to climb. Household income remains near the historic high, despite some layoffs and cooling wage growth.


While munis have shown resilience during periods of economic turmoil, a defensive stance may be warranted. ”I’ve positioned the funds I manage to benefit if the inverted muni yield curve — a historic anomaly where short-term yields are higher than longer term yields — normalizes,” says Vikas Malhotra, portfolio manager for CGSM — Capital Group Short Duration Municipal Income ETF. Companies providing essential services, such as electrical utilities, are also attractive in a slow-growth environment.


Other compelling opportunities include planned amortization class (PAC) bonds, which are pooled single family mortgage loans backed by the federal government. PAC bonds contained in the muni index yielded 4.3%, compared to 3.1% for the index’s broader five-year subset (a similar maturity profile), as of November 30, 2023. Meanwhile, given rising wage pressures, some managers are more cautious on hospitals.


Back to basics


The Fed is likely done with interest rate increases. While the economy has held up so far and inflation has fallen from its peak, the full effect of the tightening campaign is still being felt and the U.S. is not out of the woods.


The end of the hiking cycle means bonds may soon return to the basic roles of providing income and diversification from equity market downturns, says Edmonds. “It’s been a volatile few years for bond investors, but we’ve reached a turning point in the Fed cycle where rate cuts may be coming in 2024, which would be a tailwind for bond returns. Even without cuts, income potential is still a possibility.”



Oliver V. Edmonds is a fixed income portfolio manager with 20 years of experience (as of 12/31/2023). He holds a master’s degree in statistics from the University of California, Los Angeles, and a bachelor’s degree in applied mathematics from the University of California, San Diego.

Tom Chow is a fixed income portfolio manager with 34 years of experience (as of 12/31/2022). He holds a bachelor’s degree in business analysis with a minor in economics from Indiana University. 

Kirstie Spence is a fixed income portfolio manager with 28 years of investment industry experience (as of 12/31/2023). She is the principal investment officer for the Capital Group Emerging Markets Local Currency Debt LUX Fund and serves on the Capital Group Management Committee. She holds a master's degree with honors in German and international relations from the University of St Andrews, Scotland.

Vikas Malhotra is a fixed income portfolio manager with 13 years of industry experience (as of 12/31/2023).  He holds an MBA from the University of California, Los Angeles and a bachelor's degree in business administration from the University of California, Berkeley. He also holds the Chartered Financial Analyst® designation.


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