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Bond market outlook: Prospects brighten as Fed slows hikes
Pramod Atluri
Fixed Income Portfolio Manager
Damien McCann
Fixed Income Portfolio Manager
Ritchie Tuazon
Fixed Income Portfolio Manager

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Bond markets had a difficult year in 2022 as the US Federal Reserve aggressively hiked interest rates to stamp out inflation. With the end of rate increases in sight, investors may be wondering if volatility may be replaced with relative tranquility in the year ahead.


At its December meeting, the Fed moderated its approach and lifted rates by half a percentage point to a range of 4.25% to 4.50%. Investors welcomed the downshift after an unprecedented string of four 0.75 basis point adjustments by policymakers attempting to quash inflation. But officials underscored that they will continue to raise rates to around 5% next year.


Wide-ranging challenges still lie ahead. Among them: Inflation remains stubbornly high, and economic activity is expected to slow or contract.


Here, fixed income portfolio managers from across Capital Group weigh in about what’s next for bonds.


Inflation has likely peaked, but should remain high


Even the most optimistic investors are bracing for a recession. The question is more a matter of how wide or deep the downturn will be as central banks worldwide raise rates to contain inflation. With growth expected to stall or contract in major economies including the UK, European Union, Japan and the United States, will high prices stick around in 2023?


Inflation remains high in most economies

outlook annual rates

Source: Refinitiv Datastream. U.S. data as of 11/30/22. Data for other countries/regions is current as of 10/31/22. Consumer Price Index (CPI), a commonly used measure of inflation, measures the average change over time in the prices paid by consumers for a basket of goods and services.

Demand for sectors that quickly absorb rate increases, such as housing, has predictably declined. Other areas of the economy will take more time to cool.


“The impact of rate hikes will unfold over the next several months, likely in the form of higher unemployment, fewer job openings and declining retail sales,” says portfolio manager Ritchie Tuazon.


So far, the economy has coped surprisingly well. Ironically, bright spots could feed into the inflation problem.


“Supply chain issues appear to have worked themselves out, but the labor shortage and persistent wage growth could keep inflation higher than the Fed’s 2% target range for some time,” Tuazon says. Geopolitical risks could further undermine the Fed’s efforts.


“There is a flavor of stagflation ahead,” Tuazon adds. The much-feared mix of stagnant economic growth, high unemployment and soaring prices warrants an active approach to bond investing. “I see select opportunities within the Treasury yield curve as well as Treasury Inflation-Protected Securities."


Bond funds should once again offer relative stability


Fixed income's role as a portfolio ballast when stocks are falling was of no help as the Fed continuously revised rate expectations upward.


It’s rare for both stocks and bonds to fall in tandem in a calendar year. In fact, 2022 marks the only time it occurred in 45 years. That’s because the Fed hiked aggressively at a time when rates were near zero.


Stocks and bonds rarely decline in tandem

Tandem declines

Sources: Capital Group, Bloomberg Index Services Ltd., MSCI. Returns above reflect annual total returns in USD for all years except 2022, which reflect the year-to-date total return for both indexes. As of 11/30/22.

That should change in 2023 as inflation moderates. “Once the Fed pivots from its ultra-hawkish monetary policy stance, high-quality bonds should again offer relative stability and greater income,” according to portfolio manager Pramod Atluri.


As additional cracks start to show in the economy, recession fears may take center stage. “One way or another, the consumer is going to feel more stressed in 2023. Either the economy is so strong it continues to feed into inflation, or the economy weakens and unemployment rises,” Atluri says.


But slowing growth and moderating inflation is actually a good thing for high-quality fixed income. They should lead to lower yields and higher bond prices. Staying on the sidelines to wait out market volatility could mean giving up on income opportunities and the potential for an even higher total return. “Valuations are attractive, so I am selectively adding corporate credit,” Atluri says. “Bonds now offer a much healthier income stream, which should help offset any price declines.”


Investing prior to the final rate hike has provided strong returns

Article bond

Sources: Capital Group, Bloomberg. Right chart shows date of the last hike in all Fed hiking periods since 1980, excluding the 2018 peak which does not yet have five years of data. Hypothetical 12-month dollar cost average return is the total return for a level monthly investment for 12 months starting six months prior to each last rate hike. The hypothetical five-year return annualizes the total return for that first 12 months plus four more years, assuming no additional investment after that first year. Regular investing does not ensure a profit or protect against loss. Investors should consider their willingness to keep investing when share prices are declining. Past results are not predictive of results in future periods.

Historically, investing prior to the final rate hike in a cycle has paid off. In the last 40 years, there were six hiking cycles that offer five years of returns data. Purchasing bonds regularly for a year starting six months prior to the last Fed rate hike in each of those cycles would have returned a range of 3.3% to 1.2% in the first 12 months. Longer term, that year-long investment would have provided a five-year annualized total return that spanned from 5.9% to 15.6%.


Income is back in fixed income


Bond market losses can be painful to endure, as rising rates cause bond prices to decline. The upside is that bond yields also rise, which may set the stage for higher income down the road.


The yield on the benchmark 10-year U.S. Treasury hovered around 3.47% on December 14, 2022, versus a yield of 1.51% on December 31, 2021. Yields, which rise when bond prices fall, have soared across sectors. Over time, income should increase since the total return of a bond fund consists of price changes and interest paid, and the interest component is higher.


Yields have soared across asset classes

Table article

Sources: Bloomberg, Bloomberg Index Services Ltd., JPMorgan. As of 11/30/22. Sector yields above include Bloomberg U.S. Aggregate Index, Bloomberg U.S. Corporate Investment Grade Index, Bloomberg U.S. Corporate High Yield Index, and 50% J.P. Morgan EMBI Global Diversified Index/50% J.P. Morgan GBI-EM Global Diversified Index blend. Period of time considered from 2020 to present. Dates for recent lows from top to bottom in chart shown are: 8/4/20, 12/31/20, 7/6/21, 1/4/21 and 7/27/21. Yields shown are yield to worst. Yield to worst is the lowest yield that can be realized by either calling or putting on one of the available call/put dates or holding a bond to maturity. "Change" figures may not reconcile due to rounding.

With investors better compensated for holding relatively stable bonds, the question of whether to invest in riskier corporate or high yield bonds ahead of a potential recession is an important one.


Despite gloomy headlines, consumers continue to open their wallets. “This has helped keep corporate balance sheets in pretty good shape,” says fixed income portfolio manager Damien McCann.


The reward potential for corporate investment-grade bonds at current levels is enticing, but many are vulnerable in a downturn. “I expect credit quality to weaken as the economy slows. In that environment, I prefer defensive sectors such as health care over homebuilders and retail,” McCann says.


High-yield bonds are also relatively well positioned for an economic slowdown, and their prices have declined sharply. An uptick in defaults, which the market has already priced in, could still increase in a deep recession.


“We went through a significant default cycle with the pandemic,” says bond manager David Daigle. “The underlying credit quality of the asset class has improved markedly since 2008. I do expect fundamentals to weaken from here so I’m positioning the funds I manage to have less exposure to consumer cyclicals such as automotive and leisure since demand for their products and services will likely soften.”


Why bonds are back


After a difficult year for bonds, there are reasons for optimism. Inflation has moderated, and Fed rate hikes are likely to peak in the not-too-distant future. Higher yields and the specter of a recession could also send investors back into bonds in search of relative stability and income.


Today’s starting yields offer an attractive entry point for investors and provide a cushion to further volatility. There are also compelling opportunities across asset classes that an active manager can uncover via bottom-up research and security selection. 


 



Pramod Atluri is a fixed income portfolio manager at Capital Group. He has 25 years of investment industry experience and has been with Capital Group for eight years. He holds an MBA from Harvard Business School and a bachelor's degree in biological chemistry from the University of Chicago, where he also completed the requirements for bachelor's degrees in economics and chemistry. He holds the Chartered Financial Analyst® designation. Pramod is based in Los Angeles.

Damien J. McCann is a fixed income portfolio manager at Capital Group. He has 23 years of investment industry experience, all with Capital Group. Earlier in his career at Capital, he was a fixed income investment analyst and covered energy, leisure and lodging, and rails. He holds a bachelor's degree in business administration with an emphasis on finance from California State University, Northridge. He also holds the Chartered Financial Analyst® designation. Damien is based in Los Angeles.

Ritchie Tuazon is a fixed income portfolio manager at Capital Group. He has 20 years of investment experience and has been with Capital Group for 10 years. Ritchie is based in Los Angeles.


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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. All information is as at the date indicated unless otherwise stated. Some information may have been obtained from third parties, and as such the reliability of that information is not guaranteed.