Key Takeaways

• Prospects for higher U.S. inflation appear well supported.
• Yield-chasing bond strategies can leave investors more vulnerable to further selloffs in equities.
• Investors should seek to upgrade their portfolios.

Mike Gitlin, head of fixed income at Capital Group, has 24 years of investment industry experience. He discusses the current market environment and what it means for bond investors.

Global Monetary Policy: The Tide Is Turning

Sources: Thomson Reuters, as of 12/31/17.

Q: Higher longer term bond yields have often signaled a coming upturn in inflation. What’s your outlook for U.S. inflation?

Our interest rates team thinks core inflation could reach 2.4% in 2018 — if solid wage gains continue. Productivity growth was -0.1% for the fourth quarter of 2017. If productivity remains anemic, increased labor costs will need to be borne by companies and consumers.

We are also monitoring unemployment. Analysis by our economists suggests falling unemployment could also feed through into core inflation. A decline in the unemployment rate from 4.1% to 3.5%, for instance, could push annualized wage growth a quarter of a percentage point higher.

Yields Have Ticked Up — but They’re Still Relatively Low

Source: Thomson Reuters as of 2/8/18.

Q: You’ve recently talked about the need for investors to also be mindful of credit risk in the current environment — why is that?

Credit markets are, according to various measures, somewhere between fair value and full value, and certainly not cheap. Investor demand has pushed down yields on corporate bonds. Their yield gaps (or, spreads) to Treasuries have approached record tight levels.

Fundamentals for the companies issuing these bonds remain broadly supportive. Even so, it wouldn’t be surprising to see credit spreads widen back out from here.

The hunt for yield has led some bond strategies to increase their investments in credit, including high-yield corporates. This could pose a particular challenge right now because high yield tends to be highly correlated with equities.

Put differently, some core bond strategies may not provide the diversification from equities that investors expect. That could be a problem.

Q: How widespread is scope creep among bond strategies? Many bond funds appear to have strayed from their original missions in the low-interest-rate environment of the past decade.

To dig deeper, we conducted our own simple study centered on Morningstar’s short-term bond category. This is a category that should be all about capital preservation and diversification from equities.

We focused on funds that notched top-quartile annualized returns for the three years ended December 31, 2017. We found that the majority of funds that fared exceptionally well had also taken significant risks.

Indeed, many seemed to behave more like credit funds, not the kind of conservative fund that a retiree might chose as a reasonable yield enhancement over money market funds.

Q: So, some bond strategies have been overly focused on finding yield, what should investors be looking to achieve with their fixed income?

Many bond funds may be taking more risk than their clients are aware of. It’s important that investors refocus on the four primary roles of fixed income in a balanced portfolio: diversification from equities, income, inflation protection and capital preservation.

That is exactly how we use fixed income in our target date funds, and it’s how we think advisors should think about bond portfolios for their clients.

For most investors, maintaining a long-term perspective is a critical step towards achieving their goals. This means maintaining an appropriate balance of equities and fixed income through volatile periods.

That said, the current pullback may present a great opportunity for investors to upgrade their bond portfolios to what we refer to as true core: that means reallocating to bond funds that offer the potential for both solid income and diversification from equities.