Fixed income in recovery

Rich valuations, low rates accentuate the need for portfolio construction

Luke Farrell
Fixed Income Investment Director

Key takeaways

  • Our core bond strategies delivered solid returns during the third quarter
  • Portfolios became more defensive as bond valuations rose
  • Potential market volatility underscored the importance of careful portfolio construction

The economic recovery accelerated in the third quarter, supporting risk appetite in financial markets as the economy continued reopening, the employment statistics improved and COVID-19 infection rates slowed. Ongoing open market asset purchases by the U.S. Federal Reserve continued to provide a floor for market sentiment. The Standard & Poor’s 500 Composite Index gained 8.9% and reached a record high during the quarter, while bond valuations rose across most sectors.

Investment-grade (BBB/Baa and above) credit spreads over U.S. Treasuries narrowed by 14 basis points (bps) to 136 bps, near historically tight levels on a credit risk-adjusted basis. Investors continued with strong allocations into high-yield (BB/Ba and below) credit, pushing prices higher and resulting in a more pronounced spread tightening of 109 bps to 517 bps. Mortgage-backed securities tightened by 9 bps to an option-adjusted spread of 61 bps. The 10-year Treasury Inflation-Protected Securities (TIPS) breakeven spread widened by 29 bps to end the quarter at 163 bps. Corporate bond issuance was strong but down from record-high levels earlier in the year.

Renewed focus on downside protection

Our portfolios entered the third quarter with a broad overweight position in credit risk, a more neutral position in duration and a modest overweight to the long end of the yield curve. As the quarter progressed, managers reduced the allocation to investment-grade corporate bonds, and across most sectors, portfolios were slowly positioned higher in credit quality.

Through the quarter, managers harvested gains as fixed income valuations continued to rise. As a result, portfolios are now more balanced, with reduced credit exposure and more neutral positioning in duration and curve decisions. This more cautious positioning reflects heightened economic uncertainty, the risk of market volatility around the election and the potential for a second wave of COVID-19 cases through the fall and into the winter. Managers have refocused on downside protection and balancing the four roles of fixed income in our True Core approach: diversification from equity risk, income, capital preservation and inflation protection. They are maintaining enough liquidity to take advantage of any spread widening in coming months. Within each strategy, we expect security selection to be the driver of returns if valuations remain elevated or rise further.

Strong results for taxable core bond strategies (Class R-6)

Our flagship core bond strategy, The Bond Fund of America®, has returned 9.41% year to date through September 30, 2020, and generated 262 bps of excess returns versus its benchmark, the Bloomberg Barclays U.S. Aggregate Index. 

American Funds Strategic Bond Fund℠ is our core-plus strategy but uses a differentiated approach to core-plus investing. This fund continued to have outstanding results with year-to-date returns of 16.48%. The fund has generated excess returns of 969 bps year to date. Like Bond Fund of America, it rotated into credit at the beginning of the second quarter and has selectively reduced credit and interest rate risk through the third quarter.

Low interest rates, high valuations put portfolio construction in focus

An extended period of low interest rates and rich valuations across many credit sectors has complicated portfolio construction for many investors. We continue to believe that this is not the time to reach down in credit quality to generate extra yield, nor to reduce liquidity in the fixed income portion of investor portfolios. Our approach continues to focus on the four roles of fixed income, starting with a solid allocation to a True Core fund like The Bond Fund of America.

For investors who need additional income, our preferred approach is to add American Funds Multi-Sector Income Fund℠ to the fixed income portfolio for those comfortable with the additional risk associated with this fund. This fund can enhance the income generation of the fixed income allocation, but with two key advantages. First, it has a broad market duration, which can help to reduce its correlation with equities. In addition, it has the flexibility to rotate among four different income sectors, seeking to optimize income and mitigate downside price risk. Balancing Multi-Sector Income Fund with Bond Fund of America can result in a strong core fixed income allocation, with a tilt toward higher income.

A different approach for clients needing higher income — or total return — from fixed income could come from combining American Funds Strategic Bond Fund with Bond Fund of America. This pairing can provide a similar economic outcome but may deliver more return from appreciation than yield, along with enhanced liquidity and a lower equity correlation. This option may appeal to investors with a slightly higher equity allocation in their overall portfolio. 

For investors whose objective is to preserve wealth by increasing capital preservation and equity diversification within their fixed income allocation, we might suggest a slightly different tailored solution. It still begins with a solid allocation to Bond Fund of America, and then layers in an allocation to Intermediate Bond Fund of America®. The shorter duration and higher credit quality of this fund, combined with the high-quality, True Core nature of Bond Fund of America, can enhance both the capital preservation and equity diversification components for investors seeking more downside protection. This pairing may provide a strong ballast, with optimal ability to rebalance into equities should there be another market correction.

Short-Term Bond Fund of America® in combination with Bond Fund of America can deliver a similar economic outcome, but its shorter duration and higher credit quality may improve the capital preservation and equity diversification characteristics of this portfolio option. This pairing may also provide a strong ballast, with optimal ability to rebalance into equities, and should provide a better return than cash.

Positioning for heightened market volatility

As we look out over the next 12 to 18 months, we remain encouraged about the prospects for an economic recovery. Nevertheless, we continue to expect heightened market volatility as a result of the election, the coronavirus pandemic and geopolitical tensions. In this climate, we are positioning our portfolios to maintain liquidity, hold securities that represent good value, broadly protect against equity volatility and preserve capital. We continue to expect our bond funds to behave like bond funds and deliver balance and ballast in an overall portfolio.

Investment results and analysis

Mutual fund results (R-6)

Quarterly attribution reports (CITs and mutual funds)

All returns are for Class R-6 shares unless stated otherwise.

Results as of September 30, 2020. Figures shown are past results and are not predictive of results in future periods. Current and future results may be lower or higher than those shown. Share prices and returns will vary, so investors may lose money. Investing for short periods makes losses more likely. View fund expense ratios and returns.

Returns shown at net asset value (NAV) have all distributions reinvested.

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 mutual fund prospectuses and summary prospectuses, which can be obtained from a financial professional, and should be read carefully before investing.

Investment results assume all distributions are reinvested and reflect applicable fees and expenses. Returns for one year or less are not annualized, but calculated as cumulative total returns.

When applicable, investment results reflect fee waivers and/or expense reimbursements, without which results would have been lower. Read details about how waivers and/or reimbursements affect the results for each fund. View results and yields without fee waiver and/or expense reimbursement

There may have been periods when the results lagged the index(es). Certain market indexes are unmanaged and, therefore, have no expenses. Investors cannot invest directly in an index.

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The use of derivatives involves a variety of risks, which may be different from, or greater than, the risks associated with investing in traditional cash securities, such as stocks and bonds. Interests in Capital Group's U.S. Government Securities portfolios are not guaranteed by the U.S. government.

The return of principal for bond portfolios and for portfolios with significant underlying bond holdings is not guaranteed. Investments 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.

We offer a range of share classes designed to meet the needs of retirement plan sponsors and participants. The different share classes incorporate varying levels of advisor compensation and service provider payments. Because Class R-6 shares do not include any recordkeeping payments, expenses are lower and results are higher. Other share classes that include recordkeeping costs have higher expenses and lower results than Class R-6.

Class R-6 shares were first offered on May 1, 2009. Class R-6 share results prior to the date of first sale are hypothetical based on the results of the original share class of the fund without a sales charge, adjusted for typical estimated expenses. Results for certain funds with an inception date after May 1, 2009, also include hypothetical returns because those funds’ Class R-6 shares sold after the funds’ date of first offering. Please see for more information on specific expense adjustments and the actual dates of first sale.

Bond ratings, which typically range from AAA/Aaa (highest) to D (lowest), are assigned by credit rating agencies such as Standard & Poor's, Moody's and/or Fitch, as an indication of an issuer's creditworthiness. If agency ratings differ, the security will be considered to have received the highest of those ratings, consistent with the portfolio's investment policies. Securities in the Unrated category have not been rated by a rating agency; however, the investment adviser performs its own credit analysis and assigns comparable ratings that are used for compliance with applicable investment policies.

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Portfolios are managed, so holdings will change.

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