I'm Harry Phinney and this is Capital Ideas, your connection with the minds and insights helping to shape the world of investments. Today's topic focuses on fixed income. After one of the most challenging years in recent history for bonds, will 2023 look any different? Today we're going to walk through why we think it could. But first, it's important to provide some context around why 2022 was so challenging. From there, we'll briefly touch on the current state of the four roles of fixed income and why they're so important as we think about 2023 and beyond.

So, what happened in 2022? Well, as many of you will remember, we came into the year with inflation at rates at which we hadn't seen in multiple decades. Throughout, really, parts of the recovery of the pandemic, you had central banks and other policymakers that were effectively arguing that they felt as though inflation was transitory, yet they continuously suggested otherwise. It was continuing to suggest to us, in fact, that inflation was far stickier than what the central banks had initially thought it would be. So, with that, what we knew coming into 2022 was that there was going to be a policy response from major central banks, namely they were going to have to raise interest rates to begin fighting the inflationary impulse that felt like it was beginning to get out of control. But with starting yields so low, the likelihood that there would be a volatile response to these rate hikes was high. And, sure enough, the market delivered in that regard in the worst possible way.

So what we saw, from the Fed, in particular, and other central banks was a very aggressive policy stance. In the US, the Fed raised interest rates seven times in 2022. That type of hawkishness we haven't seen, really, in decades. And this meant that, basically, the Fed took interest rates from a near zero percentage point basis to over 4.5% by the end of the year. And, as we expected, and as we've talked about, the hawkishness that they implemented policy wise and that other central banks, like the ECB, did as well, wreaked havoc on the bond market. And what we saw was that every major sector posted significant declines throughout the year. In some cases, places like core bonds, those areas tend to be the safest parts of the bond market posted their worst declines in over 40 years.

This is clearly a challenging period for investors as, typically speaking, we would expect our core bonds to provide some sort of measure of protection in the market. This time around, however, they behaved, essentially, just like equity markets. And, for the first time in many years, we observed a positive correlation between both equities and fixed income. Very, very challenging for investors and certainly left, I think, many very concerned about what role can bonds really play in my portfolio if, in fact, they're going to just behave like equities.

Well, the good news is that, as the yield levels rose so meaningfully and bond prices fell throughout the year, a number of attractive opportunities across the market began to emerge. And the other good news is that the intended effect of the aggressive rate hikes, namely cooling inflation, appears to have begun to work. And so as we're starting to see in 2023 and even towards the back half of 2022, the rate of inflation across many of the major global economies began to come down meaningfully. And so it does suggest that these policy measures, although severe, are having the intended effect. But the bad news, and what we'll talk a bit about today, is that, of course, , with these aggressive rate hikes, what we also are seeing is the potential for recession. Aand we're seeing the risk of recession rise meaningfully, as we come into 2023. And, as you talk to investors and others, I think there's a genuine concern the potential risk for recession is now quite high, um, either some point during this year or in early 2024.

So what does that mean for fixed income portfolios in '23? Well, first and foremost, let's have a quick reminder of what the four rules are of fixed income. When we think about a balanced portfolio, there are four main roles that fixed income is there to play. First, and most importantly, is diversification away from equity risk. So, generally speaking, again, when we think about more normalized market environments, your core bond allocations are there to provide balance against the broader volatility that you typically observe during segments of the economic cycle, but typically through equities. So those higher quality bonds are there to provide that ballast to risk, uh, that's so important to ensuring a balanced portfolio.

Secondly, and linked to the first, would be capital preservation. So, thinking about the very, very, most conservative segments of the market that you're invested in, sort of the highest quality bonds that you can buy, those bonds tend to provide some capital preservation benefits as well. So, again, they'll protect some of your investors' money during those periods of volatility.

Third would be income generation. Now, this is interesting because if we think back over the past, you know, over a decade now, almost 15 years, what we can observe is that, in fact, it's been a very challenging period for income generation, dating all the way back to the global financial crisis where extreme measures were taken on the other side, in terms of dovishness fromthe Fed and other central banks lowering interest rates to near zero if, if not to zero exactly. So, what had happened there in that type of environment, of course, was that, generally speaking, there was really no income to be had. You know, income sectors, of course, their yields fell alongside with the broader market and so investors, for now many years, have been really reaching for yield, looking for areas of the market that tend to actually be a lot more correlated to the equity market, tend to be much lower quality, just to generate some small measure of income. Today, actually, that has changed quite a bit due to the market environment we, we referenced in 2022. And we'll talk a little bit more about that. But again, income is a very important of the four roles of fixed income.

And then last, certainly not least, would be inflation protection. Now, again, inflation protection is another one of those topics that, for years, has sort of been on the back burner, really the back of minds for investors but, very much now, of course, is at the forefront given that it is the key driver in terms of market volatility right now, as that is the key metric that central banks are trying to affect with their hawkish policies. Again, the good news here as we get into our conversation around 2023 is that we do think there are ways to protect your portfolio from inflation as we do expect to, although definitely peaked at this point, to remain elevated.

So, with that background, let's just talk a bit about the opportunity in 2023. First and foremost, we have to immediately start off with the fact and, and, and admit to ourselves that, yes, 2022 was not a good year for diversification from equity or capital preservation. So those two roles, basically, were nonexistent for bonds during that period of time. Bonds and equity markets, as I mentioned previously, they sold off in tandem and we think a lot of that has to do with not only just the starting yields, in terms of 2022 because we did come in to the year with the Fed still having interest rates pegged around the zero threshold, but also, too, the aggressiveness of their policy stance. The fact that, of the seven hikes I mentioned, four of those were 75 basis point hikes. We haven't seen aggressive measures like that since the 1990s. So, looking at that and just looking at the fact that over the course of less than a year rates went from roughly 0% to almost 4.5%, that's a huge move in markets. And, when you have that starting basis of essentially almost no yield,  that creates the potential for a lot of volatility. And that's exactly what we saw.

But it also means that it's unlikely we're going to see a repeat performance in 2023. Rather, what we think is that, as the risk of recession and uncertainty continues to swirl in the market, we expect core bonds to get back to doing their job. Given the fact that now price levels are, are diminished across the board, yields are much higher, and, importantly, the fact that we now believe that the Fed and other central banks are quite a bit of the ways through their rate hiking cycles, so in other words they're further along  hiking rates that they're not at this point. We think that the core bond allocations that you have in your portfolio are going to get back to providing that ballast against equity risk. And again, in the most conservative portfolios, we think that those bonds at the highest quality spectrum will begin to provide some capital preservation benefits as well.

It's not to say that we're completely out of the woods and I want to make sure that that is clear. The Fed has indicated,  and the market definitely concurs that there are more rate hikes to come. In fact, we expect next month the Fed to likely raise interest rates another 25 basis points. And, ultimately speaking, the terminal rate probably gets somewhere between 5% to maybe even 5.5%. So there are more rate hikes on the horizon,  but to my prior point, the bulk of those hikes, and certainly the magnitude of those hikes,  feel like they're pulling back into a more predictable, sort of more normal territory. And we expect the market to react somewhat favorably to that. But nonetheless, there are still risks in the market. Certainly that volatility may remain. The difference is, again, though we expect these core bonds that are in your portfolio to begin to behave the way that they are supposed to.

So, moving to income, I had mentioned earlier, just the potential for income generation now being far better than it has been over the past 10 to 15 years, and that's absolutely true when you look at just starting yield levels across the major income sectors. So, for instance, if we look in the credit side of, of the ledger,  corporate bonds are offering yields of over 5%. Their high-yield corporate counterparts are offering yields of over 8% and emerging market bonds are offering yields of just over 7%. These are some of the highest yield levels we've seen in years. And the important part about this, too, is that if we look at those starting yield levels, we've observed that, historically speaking, when you  project three to five years out, the actual total return potential for these bonds is quite high. Now, of course, I have to caveat that and say that past is not always a predictor but we have looked observationally at periods in the past where yield levels have been similar across these various sectors and, again, the total return potential is very high. So we do anticipate that, going forward on that three to five year basis, these three areas of the market may provide investors with not only significant income generation but, also, very attractive potential total return.

The other important part to mention is that fundamentals remain quite decent  across most of the income sectors. You know, when we think about the credit sectors themselves, leverage ratios are reasonably low and, at the same time also, due to refinancing activity that was completed in late 2021, many of these companies have also locked in lower rates on their debt for longer. So that means that interest costs will remain reasonable and, at the same time, there's no real imminent maturity well coming in the next couple of years. These are all very important factors when we think about the valuations and the potential for these bonds to generate positive returns on a go forward basis.

Similar to, to that was high-yield. The high-yield default cycle we had, actually a mini default cycle back in the early part of COVID, and we therefore think that default rates will  remain relatively low for high-yield throughout even a potential economic downturn. Now, we do know that observationally, during periods of recession,  at least in the beginning parts of recession, high-yield spreads can widen meaningfully. And so that may happen again this time. But we would just say that the starting yield levels are much higher now,  and, at the same time, again, we think fundamentals are in relatively better shape than they have been in cycles past such that overall default cycle may remain relatively muted compared to other cycles. So, something to think about there in terms of the potential for high-yield. We would just caution that having a bit more of a quality bias is likely the right approach.

And then lastly, emerging markets. So, emerging markets have been, really, an interesting area of the market here for the past, you know, two years or so. Namely because some of the largest markets out there actually were the most proactive in terms of raising interest rates. EM as, as a whole has suffered the same sort of concern and, and issues around inflation that we have in the developed world but, rather than wait and sort of hope for inflation to go away and be transitory,  the central banks across many economies, particularly in Latin America, were actually much more proactive and so they ended up raising interest rates quite meaningfully. In the case of Brazil, they've taken rates in the early part of '21 from 2.5% to today  almost 14%. And they made those rate hikes in, in a period of just about over a year, year and a half or so. So, that means that starting interest rates are much higher. But also it's had the intended effect, as Fed policy and others have had too, to a lesser degree. Namely, inflation's beginning to come down.

We've seen inflation roll over across a variety of economies, again, primarily in Latin America. And we do see opportunities to invest there because, generally speaking, not only are starting nominal yields very attractive, but, as inflation comes down, those real yields can become attractive as well. And, more importantly, when we think about, now, the potential for recessionary environment, globally, there's a lot of runway for these central banks to lower interest rates,  in terms of counter-cyclical policy to, essentially, try to fight or support the economy, if you will, fight the recessionary pressures that may exist going forward.

So this is important too, because as I've talked briefly about that last role of fixed income inflation, because inflation protection, of course, is key. As I mentioned earlier, although the trend is beginning to move in the right direction with inflation coming down somewhat,  it is still quite elevated, in some cases at multi-decade highs. So how do you protect your portfolio against inflation? Well, some of these credit sectors I mentioned earlier are a good place to allocate to. The higher the yield that they offer, typically, the more they're able to insulate an investor from the punitive effects of inflation. In many markets, also, inflation protection securities too and, in the case of the US, TIPS are places that investors can also invest that are linked to the inflation rate itself so they provide some measure of protection as well. But, generally speaking, looking for those either inflation-linked securities or areas of the market that offer relatively attractive and higher yield, that provides some ballast, we would say, against the inflation risk that continues to exist in portfolios and in markets, broadly speaking. Again, with the hope being that the continuing trend will be downward in terms of inflationary impulse, that we begin to, to wind our way back to the target rates which, for many central banks, is around 2% or so.

So, with all of that, in summary, what I would say is that we are not out of the woods yet in terms of the risk of recession. Particularly as that has risen meaningfully, I think, as we enter 2023 here. But the good news is that we do think bonds are poised to deliver for investors this year and going forward. Based on a combination of factors around where valuations stand, the fact that we do think policy rates have largely moved directionally where they're going to move again, there are more rate hikes to come but we feel as though, barring any sort of upside surprise to inflation, those rate hikes will besignificantly smaller than what we saw in the first part of 2022. They'll probably be less frequent and we do believe we're moving down toward the path, potentially of the Fed ceasing their rate hikes. When that will occur, we don't have an exact sort of crystal ball around timing. But, potentially, by the second half of the year, you may see that pause that the market is anticipating from the Fed,  alongside also, of course, the ECB and, and other major central banks as well. Which although they haven't been as aggressive, they've certainly taken by recent historical standards, fairly aggressive measures.

But, with starting yields at their highest levels that they've been in years, as I mentioned, the inflation data beginning to moderate, we do think that core bonds should, yet again, provide investors with the protection that they need from these volatile markets. Likewise, you know, the yield that we mentioned on income-focused bonds are some of the most attractive that we've seen in years. And we think that that positive income generation potential is really an important story here that hasn't been part of the bond market narrative for the past decade plus. So it's a good time to be an investor because you can invest, basically, across the risk spectrum, from the most conservative bonds and treasuries all the way through high-yield and emerging market credit and, along the way, pick up positive carry and positive yield. This, we think, is going to help investors position for success in 2023 and also, again, position for what may be a volatile market going forward in the near term.

So, with that I will stop my comments here and thank you very much for your time. We're always trying to get better so if you have any feedback, including topics that you'd like to see addressed in future episodes, send us an email at CapitalIdeasPodcastAustralia@CapitalGroup.com. Again, that's CapitalIdeasPodcastAustralia@CapitalGroup.com. For Capital Ideas, this is Harry Phinney reminding you that the most valuable asset is a long-term perspective.

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