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Categories
Fixed Income
Brighter days ahead for bonds despite recession risks?
Pramod Atluri
Fixed Income Portfolio Manager

After facing historic losses amid escalating inflation and monetary tightening, what lies ahead for fixed income markets? With yields becoming more attractive, fixed income portfolio manager Pramod Atluri suggests that the outlook for bonds hasn’t looked this compelling in years.  


Pramod Atluri: 

The tricky thing about inflation today is that it's not the inflation that we're used to. When supply and demand are roughly in balance, inflation is much easier to deal with. When the economy runs too hot, demand grows faster than supply and inflation heats up. Then the Fed just taps on the brakes a little bit to bring everything back in line, and inflation pressures ease, or at least that's the theory. But today we're dealing with something a little different. Today we're dealing with a massive disruption in the supply of goods and labor. There are many reasons for this. Supply chain disruptions are a huge factor, which continue even to this day, as China is only now reemerging from another COVID lockdown. But the disruptions from the Russia-Ukraine conflict are also playing a large role. Today, supply is meaningfully below demand. So, small changes in demand may not lead to large falls in inflation because it's just so far away from balanced. This makes predictions very tricky today.

In our view, the Fed likely needs to raise rates well into restrictive territory. So if neutral is something like two-and-a-half percent in the Fed funds rate, we're currently pricing in that the Fed will get to three-and-a-half to four percent in the next year. Now that certainly feels restrictive, and we are certainly seeing a significant impact from these tighter financial conditions in the economy today. The question is whether this is enough and, unfortunately, we won't know for certain until we see how inflation trends over the next few months. But my own view is that as the market prepares for a recession this year and next, we may have already seen the highs in yields. Yields have fallen almost 50 basis points in just the past two weeks as investors start to price in a recession. So, could we back up a bit again? Yes, but I think it's very possible we already saw the highs in yields for this cycle.

I think what investors need to understand is that while the fall has been very quick, the climb back from here is likely to be slow and steady.

The losses that we've seen year-to-date have been historic. I think we're maybe around negative 12 percent for the Bloomberg Aggregate Index, plus or minus, at the lows, but I think we'll probably recover all of these losses in the next two to three years. And there's additional upside if we're right that the economy will slow and inflation falls over the next year or two.                            

So it's my view that investors looking at their portfolio should view the negative returns in bonds as a really great opportunity today because bonds mature, and those returns will all come back and more. It's just a matter of time. There will still be volatility over the next couple months as inflation remains elevated and we look for peak inflation, but sometime over the next few months I really think investors should be looking to add to bonds and, in particular, high-quality bonds.

We're starting to lock in some of the yields that we're seeing here. Where earlier in the year we had been underweight duration, so underweight yields as we thought yields were going to rise.

Now we're much closer to neutral and are looking to capture these higher yields, which look attractive if growth continues to slow and inflation falls in the coming months and years. We've also changed the profile of the bonds that we own. So earlier in the year, we were owning 30-year, 10- and 30-year bonds and underweight the front part of the curve with the idea that as the Fed hikes rates it really pushes up one-, two-, three-, four- five-year yields. Well now that so much is priced into the market, those yields now look much more attractive to us.

And so we have started to reverse our curve positioning and are starting to prefer the bonds that are at the front and belly of the curve. And with the upside potentially that if the Fed is able to become a little bit more dovish, if inflation does fall, that there's extra return that we can generate from those bonds. More than just the yield that they deliver.                              

Mortgages are an interesting asset class because valuations had reached very, very extreme levels because the Fed had been buying so many of them during their quantitative easing program. Now that the Fed has gone from easing to hiking and to tightening, mortgages have really cheapened up quite a bit. And they've gotten to a point now where they're starting to look attractive over a multi-year view.                               

So that is a sector that we are looking at very closely. The one issue that we still have with mortgages is that when volatility rises and is high, mortgages tend to not do so well. And right now volatility is high, and we think it might continue to be high for a little bit longer. But with a longer term view — six months, a year, two years — our expectation is that volatility is likely to fall, and therefore mortgages present a really interesting opportunity.                               

In TIPS, treasury inflation-protected securities, that's also a fascinating market. This is an area where one might think that since inflation is so high that TIPS must have been doing fantastic. And it's true, TIPS have done quite well, but different TIPS, short-maturity TIPS versus long-maturity TIPS have done very differently. And the reason is because when you buy a short-maturity TIP, a one-year bond or a two-year bond, what you're really capturing there are the high inflation prints that we're seeing in the market today. And so those are the bonds that we really like in the portfolio because we believe that inflation is likely to stay high for an extended period of time. And we want to make sure that we can use TIPS. Longer TIPS, 10-year TIPS, 30-year TIPS, while you are capturing those high inflation prints, those long-maturity TIPS are much more dominated by inflation expectations. What is inflation going to average over the next five, 10, 30 years? And when you buy those TIPS, what you're also getting is the likelihood of a potential recession that comes and that might pull down inflation. And so as recession fears grow, we're nervous about owning too many long-maturity TIPS. Because while you might capture the high inflation prints of today, it might be overwhelmed by recessionary fears over the longer term.                               

The last thing I'd say is on corporate bonds one can now find really solid high-quality corporate bonds, even with just a five-year maturity, with yields of four-and-a half to five percent. Now that looks really attractive in my view. But the problem is that if we are moving into a recession, those could still get a little bit cheaper. So given our conservative outlook and the increasing chance of a recession, we're continuing to stay up in quality and may look to add credit a little bit more down the line when it fully prices in the risk of recession. But make no mistake, I think bonds are a buy somewhere around here, particularly high-quality bonds. There may be some volatility in the next few months, but the risk of a recession is only growing larger. And I believe that'll be reflected in demand for bonds as the year progresses.

I think everyone is right to focus on the risk of a recession. So here are some data points. Real GDP in the first quarter was negative one-and-a-half percent. In the second quarter, the Atlanta Fed GDP now is forecasting GDP growth of zero percent. And it's been trending down every day as we continue to get economic data that is weakening. So just by the definition of two consecutive negative quarters of GDP, we're flirting with it right now. Now, ultimately, we don't think we're in a recession just yet and that growth will rebound a bit in the second half. But we're talking more like growth of zero to one percent for all of 2022. And our outlook for 2023 is for growth to continue to slow as the impact of tighter financial conditions and the Fed rate hikes continue to impact the economy.

CEO confidence has fallen, consumer confidence is near record lows. Retail spending is weakening, housing activity is weakening, and inventories are piling up. Volatility and inflation are linked together right now. The higher and more persistent inflation is, the more hawkish the Fed will be and the more volatility there will be. And we think inflation is likely to remain high for at least a little bit longer before hopefully trending down. All of this is leading us in The Bond Fund of America to remain very cautiously positioned. We know that investors buy bonds because they want something to hold up when times are tough. So given our outlook, we want to maintain a high-quality portfolio until valuations get more attractive.

When you go around the world, what we're seeing is that as interest rates were all too low, inflation is a global phenomenon. And now we are going into a period where global monetary policy is all hiking at the same time. I think this amount of coordinated monetary policy tightening is pretty unprecedented, especially in modern times.

The two or three things I would like the listeners to leave with is one — inflation is high. It's higher than anyone wants it to be, but it's likely to persist for a little while before it starts to settle down. And so anyone who is sitting on a high cash portion in their portfolio is currently losing eight percent because of inflation. So one, understand that cash is a big drag on your portfolio. Two, as inflation peaks in the coming months and investors look ahead to slowing growth and possible recession, bonds will likely resume their role as a diversifier that will provide ballast and reduce volatility. And then three, with yields close to around four, four to five percent for high-quality bonds with additional upside as the economy slows and inflation falls, the outlook for bonds hasn't looked this good in years.

 

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This material does not constitute legal or tax advice. Investors should consult with their legal or tax advisors.

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.

Bloomberg U.S. Aggregate Index represents the U.S. investment-grade fixed-rate bond market. This index is unmanaged, and its results include reinvested dividends and/or distributions but do not reflect the effect of sales charges, commissions, account fees, expenses or U.S. federal income taxes.

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In exclusive footage from our Midyear Outlook webinar, he explains the multiple factors driving inflation, identifies which types of bonds appear most attractive now and discusses how he’s positioning portfolios amid global monetary tightening. 


Date recorded: Thursday, June 23, 2022



Pramod Atluri is a fixed income portfolio manager with 23 years of industry experience (as of 12/31/2021). He holds an MBA from Harvard and a bachelor’s degree from the University of Chicago. He is a CFA charterholder.


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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.

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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.