Fixed Income
Episode 6 - Bonds are back
Flavio Carpenzano
Investment Director

2022 was an unsettling year for investors. With equities and bonds declining in tandem, the roles of fixed income as a defensive allocation and a portfolio diversifier were called into question. Fixed Income Investment Director Flavio Carpenzano explores what has changed in 2023 and explains how investors can benefit from selective exposure to bonds for portfolio resilience in uncertain times.

Flavio Carpenzano is an investment director at Capital Group. He has 18 years of industry experience and has been with Capital Group for two years. He holds a master's degree in finance and economics from Università Bocconi. Flavio is based in London.

Flavio Carpenzano: Hello, everyone. I am Flavio Carpenzano, and this is Capital Ideas, your connection with the minds and insights helping to shape the world of investment. In today's session, we are going to discuss the opportunities in the fixed income market. We had a very bad year in 2022, and probably bonds are back. So, we go through the reasons why we think bonds are attractive, the role that they have in the portfolio particularly in the current economic scenario where uncertainty still remains elevated.

Before going into details, let me step back and understand why 2022 was a disappointing year for bond holder investors and, actually, was one of the worst years for bonds in the last 40, 45 years. So, it was definitely bad. And the reason for that is because yields, they went higher across the globe. But I think there is a little bit more to it than that and I want to frame why it was so bad, giving the three main reasons why it was the worst performance of fixed income markets last year – and I want to use this as a framework to understand what can happen in 2023.

And so, if you look back at 2022, we had one of the largest shifts in yield, where yields all over the asset classes moved between three to six per cent. And the reason for that was because central banks, thought inflation was transitory and then they realized that inflation was more persistent, and so they moved rates and increased rates quite fast. So, that is the first reason. But the second reason was the speed of the adjustment in price, the speed of the increase in yield, which was very fast. This sharp increase happened in just a few months, and this is very bad. I mean, one thing is that it is increased by three or five per cent in a couple of years. One thing is that you have the same amount of change in just a few months. So that is the second reason, the speed of change in the yield.

And there is a third one, which for me is the most important thing, is that we entered this phase of volatility last year in 2022 with a yields level that were at the low historical point. So just to give you an idea, an asset class, a risky asset class involves like high yield corporates was yielding just three and a half per cent. Why this was a negative? Because, the bond market, with the yield so low, did not provide any protection for this mark to market for this price adjustment. So, really if you summarise, it was the worst year for fixed income because one, yields they moved higher, they moved fast, and with no protection from income.

Now, if you used this very simple framework to understand what can happen in 2023, yields can still go higher from here. Spreads on corporates, they can still go wider and they are relatively fast. We can see how volatile the market is at the moment, but there is one main difference compared to 2022. And it is the fact that the starting yield is very high. Because one of the outcomes of the repricing that we saw last year was the fact that today, the bond market across different asset classes, from government bonds to high yield, offers a level of yields that we haven't experienced in decades, and this is important. A, because the yield is the proxy for your future return. B, because the yield, the income, is a protection for mark to market volatility. And that is why we can say that bonds are back, and that's why we can say that bonds remain extremely attractive today.

Now if you look over the long term, and at Capital Group, we tend to have a long-term view, we are pretty comfortable to say that bonds at this level, they offer once in a lifetime opportunity. So, they offer a very attractive entry point over the long-term. Again why? Over the long-term yields, the starting yield is a proxy for your future total return, and that is why when you have an asset class like investment grade corporates at five and a half percent, you have a high yield at nine per cent, over the long term, they might offer this kind of a high level of return, between six and 10%, for an asset class like fixed income.

However, over the short term, we appreciate that uncertainty remains extremely high, volatility remains extremely high, and so a more conservative position is definitely warranted. And when you look at the uncertainty, today our main concern is the fact that central banks are facing a big dilemma around the world, which is either pursue price stability and put inflation under control, but unfortunately to do that, they need to increase rates dramatically, and they did that. And recently, we started to see the first impact of such a high level of rates in the financial market, in the banking sector with the sort of financial instability. With the banks, some banks got into trouble in the US and Europe.

And so, you can start to see some fragility in the system, in the financial system that central banks, they cannot ignore. So, we are really at a turning point where it is true that inflation is elevated. It has probably reached a peak and probably is going to slow down. But to slow down, if it slows down quite quickly, unfortunately you need a recession. And so how to position from that perspective?

And then, when we look at opportunities like across the fixed income market, I think it's important again to do a step back and ask ourselves the question, why do we buy fixed income in the first instance? Why do we buy bonds? And I think that is the key question to answer to realise then, which kind of bonds we want to invest in and why do we buy them? And from the perspective, there are, I would say two main macro reasons we buy bonds. We buy bonds, and here I am talking about high quality government bonds, US Treasuries, Australian government bonds, German bunds, very solid high quality government bonds, or high-quality investment grade corporates. And we buy these kinds of bonds usually for capital preservation or as a diversification from the equity exposure that we have in the portfolio.

On the other hand, we can buy riskier bonds like high yield corporates, emerging market debt. And usually the reason we buy these kinds of bonds is more for income generation; or today, given the high level of income that they provide, we buy them for sort of inflation protection. Inflation still remains elevated, so in real terms, they still offer a good real positive income. So, these are the two main buckets, income on one end, and the capital preservation and diversification from equity on the other end.

So, if you look from that perspective again, not all bonds are born equal. So, we talk a lot about fixed income, but reality, the fixed income world and the fixed income markets are very different, the bonds are different and they have different purposes. So, while I appreciate that this might sound very basic, sometimes you go back to the basics and why we invest in bonds is absolutely crucial.

So, we should look more at the objective, or the reason why, rather than just look at the short term. And what is important when we look at the capital preservation and diversification from equity. It's true that last year in 2022, bonds, in particular government bonds, they really disappointed in this role of diversification versus equity because when you look at last year you had equity markets going down quite dramatically, and the government bonds, US Treasuries, for example, going down by the same level of equity. So, they did not offer any diversification, and in reality, there was no place to hide in the market.

So, we appreciate the frustration, but what is important is do not take a year like 2022 and extrapolate like this is the new normal, because this is not the new normal. And the reality, we already see in a year like 2023, where the main risk is not necessary anymore and sustained inflation, but it started to morph into more and higher risk of recession. When you have this increasing risk of recession, you can see how adding high quality government bonds or corporate bonds in the portfolio actually provides diversification.

So, look just in a month like March, which was extremely volatile. You see the equity market actually under a lot of pressure, while you will see relatively strong performance from government bonds. So, they did perform positively up of two per cent just in March. So, you started to see already when volatility kicks in, how the importance of adding government bonds in your portfolio to provide diversification versus the equity exposure that remains absolutely crucial over the long term, but adding bonds try to protect or limit your downside.

On the other hand, income. Income is something that, again disappointed over the last, I will say probably decades. We have been living over the last 10 years in what we saw as a low yield environment with income very low. And, as I mentioned at the beginning, we used to invest in the markets like high yield, where the yield in 2021 was just three and a half percent. So, we were talking about income, but there was no real income. Today, the good side of adding such a quick sell-off is the fact that the market repriced quite quickly, and today you can invest in an asset class like US high yield or emerging market debt, where the level of yield is between eight to nine per cent. So, it is quite attractive. We are talking about really a proper high income solution.

And that's why adding a diversified solution, where you invest either in high yield or emerging markets, or better, in a combination of the two, which provides diversification itself, it's a good way to provide a high level of income – to provide a real positive income where you adjust for inflation, and so from that perspective, for those clients, that they have a more income need, like they're close to retirement and so on, finally bonds, and particularly the risky part of the bonds, they provide a good level of income.

I think there is another aspect when you compare the relative value between high yield versus the equity market. Even if equity markets still provides an opportunity over the long term, volatility in the short term remains quite high. And the same is true for high yield, because of course it is very correlated with the equity market. The main difference comes to the point that bonds provide a regular income, a regular coupon and less of default. You do not have the same feature in the equity market where stocks, the dividend they pay, is fully discretionary.

So, that is why for generating income, you can either focus on the dividend strategies in the equity market, but for sure the bond is your natural solution for generating this constant coupon that again might serve some purpose. And, in particular, this volatile environment, again as I said, adding an income provides a cushion, a buffer for mark to market volatility. This is expected to remain very high.

So, to summarise, bonds are back over the long-term. Really, it's an attractive opportunity. The level of yields that we see today between five per cent for a high-quality investment grade corporate, up to nine per cent for high yield, are levels that we have not experienced in decades. So, gradually entering this market over the long term provides a very attractive entry point. Over the short term, uncertainty, as we will see, remain extremely high, and that's why active management and diversification is absolutely crucial in this environment. And when we talk about diversification, if you want to diversify versus your equity exposure, for sure government bonds or high quality corporate bonds, they still provide an attractive yield, and at the same time, they provide diversification.

An alternative, if you want to de-risk from your equity exposure and you want to add more income in your portfolio because that is the need, finally asset classes like high yield and emerging markets, they can provide a very attractive level of income that we haven’t experienced in decades. I hope you find this podcast quite useful. We always try to get better. And so, please if you have any feedback, including topics that you want us to discuss in a future episode, please send us an email at And thank you very much for your attention. Have a good day.


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