Select your location

Who are you ?

Select another location

Wer bist du ?

Wählen Sie einen anderen Ort

Qui êtes vous ?

Sélectionnez un autre emplacement

Qui êtes vous ?

Sélectionnez un autre emplacement

Qui êtes vous ?

Sélectionnez un autre emplacement

Wer bist du ?

Wählen Sie einen anderen Ort

Wer bist du ?

Wählen Sie einen anderen Ort

Qui êtes vous ?

Sélectionnez un autre emplacement

Wer bist du ?

Wählen Sie einen anderen Ort

Qui êtes vous ?

Sélectionnez un autre emplacement

Who are you ?

Select another location

Who are you ?

RETIREMENT PLAN INVESTOR

Use your plan ID (available on your account statement) to determine which employer-sponsored retirement plan website to use:

IF YOUR PLAN ID BEGINS WITH IRK, BRK, 1 OR 2

Visit americanfunds.com/retire

IF YOUR PLAN ID BEGINS WITH 34 OR 135

Visit myretirement.americanfunds.com

Capital Ideas

Investment insights from Capital Group

Categories
Interest Rates
Four reasons not to fear rising interest rates
Ritchie Tuazon
Fixed Income Portfolio Manager
Margaret Steinbach
Fixed Income Investment Specialist

After a stellar 2020, the bond market is coming under pressure. Massive government stimulus measures and an improving economic outlook are combining to stoke one of fixed income investors’ biggest fears: higher inflation.


The selloff has been sharp. After rising more than 7% last year, the Bloomberg Barclays U.S. Aggregate Index is down more than 3% on a year-to-date basis. The key questions for investors: Is the selloff warranted, and are rates likely to continue rising significantly from here? Our answer to both is no.


Long-term yields have risen but remain historically low

A line chart shows 10-year government bond yields in the U.S., U.K., Germany and Japan from 2007 to present. Yields were higher as the chart begins than in 2021. However, they have begun to rise in all regions from 2020 lows.

Source: Bloomberg. As of 3/19/21.

1. The market is overreacting


We believe the market is getting carried away with rate hike anxiety. Market expectations for a Federal Reserve rate hike in 2022 are earlier than we anticipate.


Our view is based on the Fed’s desire to get the U.S. back to full employment. On evaluating the labor market, the Fed has articulated a broad approach. That means no single employment measure will work as a rate hike trigger. Fed officials will consider a variety of measures of underemployment, labor participation and even employment trends within specific demographic and income groups. Some of those, such as a weak labor participation rate, suggest labor market slack and possibly some longer term scarring. This should lead to patience on the part of U.S. central bankers when considering when to tighten policy.


Additionally, the Fed has indicated that it is comfortable allowing inflation to run “hot” — above its 2% target — for a period of time if monetary policy is helping to hasten job creation amid elevated unemployment. This is evident by embracing policies such as average inflation targeting. This policy targets an average inflation rate over a period rather than having a rigid ceiling for all periods.


For these reasons, we believe that the Fed will remain broadly accommodative. It appears likely to encourage strengthening economic activity until late 2023 or even early 2024. Fed Chair Jerome Powell seems committed to projecting any action that could tighten policy well in advance of implementation. We believe the Fed will follow a structured unwinding path. This strategy is likely to be similar to its 2013–2015 signaling that led to its first hike after the financial crisis.


How will the first rate hike unfold?

The exhibit shows a timeline from 2021 through 2023. The top part is the Fed’s dot plot of committee member median expectations and market expectations based on future pricing. In December 2022, those expectations begin to deviate with the market expecting roughly one 0.25% hike by that time. In December 2023, the Fed’s median remains at zero hikes, while the market expects roughly three 0.25 basis point hikes by that time. At the bottom of the chart are Capital Group’s rates team estimations for how the Fed is likely to signal a rate hike. It may begin in the second half of 2021 by announcing an intention to taper asset purchases, with an actual program to do so to begin in the first half of 2022. That program would probably end in the last quarter of 2022 or the first of 2023. It would then signal a first rate hike after that time.

Source: Capital Group, Federal Reserve. As of 3/22/21. Fed dots represent the median Federal Open Market Committee projections when rate increases will occur. The market dots represent investor expectations based on futures pricing. The lower timeline represents how Capital Group’s interest rates team believes the unwinding path could unfold. The Fed is likely to "taper," meaning to reduce its asset purchases, as an early step towards policy normalization prior to raising rates

Due in part to our view on the Fed, we find shorter term U.S. Treasuries attractive at present. If the market comes around to our view on monetary policy, these yields could decline and associated bond values rise. We are neutral on longer term Treasuries.


The combination of loose monetary policy and fiscal stimulus has led inflation expectations to rise over the past few quarters. That has helped boost values of Treasury Inflation-Protected Securities (TIPS). However, the Fed’s tolerance for moderate inflation could lead expectations to rise further. This may occur if the central bank’s policy remains stimulative for longer than the market currently anticipates. If those expectations rise, so too will the value of TIPS.


What if we are wrong and higher rates are rapidly approaching? Even then, there are strong reasons to stay invested in high-quality bonds.


2. Rates are rising for a good reason — a strong recovery


Growth and inflation expectations have picked up, as markets are seeing light at the end of the pandemic tunnel. Vaccines are steadily rolling out, and infections are on the decline: These are harbingers of stronger growth. They also underscore that the improving U.S. labor market trend will likely continue as COVID-19 restrictions lift.


These positive factors have not prompted the Fed to signal rate hikes. However, their commitment to maintaining low rates amid more robust economic activity has helped boost inflation expectations. The Fed has pledged to endure moderate inflation to cut unemployment further. Yet the market believes rising inflation could mean higher rates are not that far off. An investor consensus projects an initial hike in 2022.


Inflation expectations are rising

The line chart displays 10-year break-even inflation rates for the U.S., U.K., Germany and Japan. It begins in 2015 and runs through the present. It shows inflation expectations mostly vacillating around similar levels for each country but increasing visibly in recent months for all four countries.

Source: Bloomberg. As of 3/19/21. Break-even inflation rates convey the average inflation required over the life of an inflation-protected bond and similar nominal bond to generate the same total returns.

3. Core taxable bonds have shown resilience amid rate hikes


Bond values decline when rates rise. But history suggests that this isn’t the whole story. When rates rise, they historically haven’t done so quickly and sharply enough to cause significant losses over a hiking cycle for core bond investors.


The yield bonds offer investors and other factors that push up bond values can help provide a positive total return. The chart below shows rate hiking periods over the past several decades. In all those periods, only two have seen negative total returns for the core bond benchmark. Despite rising rates, the average return for these periods was nearly 4%.


Rising rates don’t always mean negative bond returns

A bar chart showing the cumulative return of the Bloomberg Barclays U.S. Aggregate Index in the last seven periods of rising rates, starting in 1983. It shows that the index return was positive in five of those periods, ranging from 2.02% to 10.18%. It was negative in two of the periods, ranging from –2.89% to –2.04%. The average for all periods was a positive return of 3.92%. It also indicates how much the federal funds rate rose in each of these periods, ranging from 1.44% to 4.25%.

Sources: Bloomberg Index Services Ltd., Federal Reserve. Data through 3/17/2021. Periods represented above include: 4/1/83-7/31/84, 1/1/87-9/30/87, 4/1/88-5/31/89, 2/4/94-2/1/95, 6/30/99-5/16/00, 6/30/04-6/29/06, 12/16/15-12/20/18. Note: Daily results for the index are not available prior to 1994. For those earlier periods, returns were calculated from the closest month-end to the day of the first hike through the closest month-end to the day of the final hike.

Recent history is probably more relevant to what we can expect from the Fed as well. When central bankers began raising rates in 2015, they did so gradually. They began with a 25-basis point hike in December 2015. The Fed then waited a full year for another. Over the next year it raised rates three more times, again by just 25-basis points per hike.


History alone may seem a compelling enough reason not to abandon your core bond allocation when rates begin to rise. However, we would argue a core bond allocation is something a balanced portfolio needs in any market environment. Having a strong core bond allocation can help to provide a measure of stability when unexpected shocks hit. Indeed, today’s market makes an even stronger case for maintaining a solid core.


With riskier asset prices soaring, we believe investors should prioritize diversification from equities and capital preservation in fixed income. Markets are reflecting the likelihood of a post-pandemic economic upswing, but there could be bumps along the way. As the market crash in early 2020 illustrated, high-quality core fixed income can serve as ballast in portfolios during periods of equity stress.


What kind of core or core-plus funds should you consider? Those that do not take excessive credit risk. Their correlation to equities — how closely tied their returns are to those of stocks — should be relatively low. At Capital Group, we strive for this outcome with our core and core-plus funds The Bond Fund of America® and American Funds Strategic Bond Fund.


4. Core municipal bonds have also shown stability amid rising rates


Like taxable bonds, municipal bonds have also felt the impact of rising yields this year. While munis have become more credit driven in recent years, rates still have a major impact. Returns for the Bloomberg Barclays Municipal Bond Index are down 0.75%, year-to-date through March 18. But as with taxable bonds, a longer term perspective can be revealing. Consider those same periods of Fed rate hikes as shown earlier for the core taxable index.


Munis have held up well amid periods of rising rates

A bar chart showing the cumulative return of the Bloomberg Barclays Municipal Bond Index in the last seven periods of rising rates, starting in 1983. It shows that the index return was positive in four of those periods, ranging from 6.59% to 12.03%. It was negative in three of the periods, ranging from –2.84% to –0.76%. The average for all periods was a positive return of 4.33%. It also indicates how much the federal funds rate rose in each of these periods, ranging from 1.44% to 4.25%.

Sources: Bloomberg Index Services Ltd., Federal Reserve. Data through 3/17/2021. Periods represented above include: 4/1/83-7/31/84, 1/1/87-9/30/87, 4/1/88-5/31/89, 2/28/94-2/28/95, 6/30/99-5/31/00, 6/30/04-6/29/06, 12/16/15-12/20/18. Note: Daily results for the index are not available prior to 2006. For those earlier periods, returns were calculated from the closest month-end to the day of the first hike through the closest month-end to the day of the final hike.

For the municipal bond index, the results are similar. In most periods, the return was positive or close to flat. The average over all seven periods was a positive return of more than 4%.


“Rising rates may help our strategies increase tax-exempt yields,” says Fixed Income Product Manager Neil Amirtha. “Narrowing spreads, the premium investors are paid for credit risk over risk-free assets, would help us take advantage of dislocated subsectors. Those include bonds from hospitals, senior living facilities and transportation issues such as mass transit. For these sectors, spreads have yet to fully normalize to pre-pandemic levels.”


Today’s muni market has already been recovering from the onset of the pandemic, with better-than-expected revenue collections. But it has another tailwind: recent stimulus measures from Washington. The 2020 CARES Act, the stimulus passed in December and the American Rescue Plan Act passed this year will all help. Together, they provide about $1.2 trillion in muni-related aid provisions for subsectors such as state and local governments, health care and education. This should further improve muni bond fundamentals.


At first glance, prospects for rising rates may make fixed income investing seem unattractive. And yet, from a vantage point that is both long term and recognizes the roles of fixed income in a balanced portfolio, it’s clear that rising rates are no reason to abandon bonds.



Ritchie Tuazon is a fixed income portfolio manager with 20 years of industry experience (as of 12/31/20). He holds an MBA from MIT, a master's in public administration from Harvard and a bachelor's from the University of California, Berkeley.

Margaret Steinbach is a fixed income investment director at Capital Group. She has 13 years of investment industry experience, four with Capital. Previously, Margaret worked as a portfolio specialist at Oaktree Capital Management. She holds a bachelor’s degree in commerce from the University of Virginia.


The market indexes are unmanaged and, therefore, have no expenses. Investors cannot invest directly in an index.

 

The return of principal for bond funds and for funds with significant underlying bond holdings is not guaranteed. Fund shares are subject to the same interest rate, inflation and credit risks associated with the underlying bond holdings. Lower rated bonds are subject to greater fluctuations in value and risk of loss of income and principal than higher rated bonds. Income from municipal bonds may be subject to state or local income taxes and/or the federal alternative minimum tax. Certain other income, as well as capital gain distributions, may be taxable. While not directly correlated to changes in interest rates, the values of inflation linked bonds generally fluctuate in response to changes in real interest rates and may experience greater losses than other debt securities with similar durations.

 

Bloomberg Barclays U.S. Aggregate Index represents the U.S. investment-grade fixed-rate bond market. Bloomberg Barclays Municipal Bond Index is a market value-weighted index designed to represent the long-term investment-grade tax-exempt bond market. Bloomberg® is a trademark of Bloomberg Finance L.P. (collectively with its affiliates, “Bloomberg”). Barclays® is a trademark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Neither Bloomberg nor Barclays approves or endorses this material, guarantees the accuracy or completeness of any information herein and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

Hear from the investment team.

Don't miss out

Get the Capital Ideas newsletter in your inbox each week

*REQUIRED

Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value.

Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the fund prospectuses and summary prospectuses, which can be obtained from a financial professional and should be read carefully before investing.

Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. This information is intended to highlight issues and should not be considered advice, an endorsement or a recommendation.

All Capital Group trademarks mentioned are owned by The Capital Group Companies, Inc., an affiliated company or fund. All other company and product names mentioned are the property of their respective companies.

Use of this website is intended for U.S. residents only.

American Funds Distributors, Inc., member FINRA.

This content, developed by Capital Group, home of American Funds, should not be used as a primary basis for investment decisions and is not intended to serve as impartial investment or fiduciary advice.