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Fixed Income
The bond reset has charted a fresh path forward for fixed income

It’s been a rough year for the financial markets — and not just for tumbling equities and formerly high-flying tech darlings. In what feels like insult added to injury, normally dependable fixed income has also been clobbered. The pain even extends to high-quality core offerings that have typically provided a stout defense whenever volatility whipped through stocks.


Stocks and bonds don’t normally experience duress at the same time. After all, fixed income typically plays the role of shock absorber, rallying as stocks retrench. But there have been exceptions to this dynamic. And in a year in which so much has veered off script, the plight of usually stalwart volatility hedges has been dispiriting.


The primary culprit has been the lightning-fast rise in inflation, forcing the Federal Reserve to raise interest rates. Bond prices fall as a consequence of higher rates. The central bank has raised its benchmark short-term interest rate three times this year, including an aggressive three-quarter-point hike in mid-June that was the first such move since 1994. Fed chair Jerome Powell has made clear that additional hikes are coming. In June, the yield on the benchmark 10-year Treasury rose to its highest level in more than a decade. (Higher rates on newly issued securities push down the value of older securities with lower rates.)


Even so, history offers cause for optimism, says fixed income portfolio manager John Queen. On a fundamental level, the merits of fixed income shouldn’t be viewed through the prism of a few months.


“When equities go down, bonds have tended to do better,” Queen explains. “However, that’s not necessarily a daily one-for-one kind of move. There will be times when both high-quality bonds and stocks drop. But investment grade bonds have been less volatile, and that’s been a valuable hedge against equities.”


The reasons for owning bonds are as vital as ever, Queen says. Fixed income can generate income, preserve capital and provide crucial diversification, especially in relation to the periodically heart-pounding setbacks that rattle equities.


Indeed, even though many fixed income categories are down for the year, most core bonds have weathered the financial market volatility much better than equities have. Consider, for example, the Bloomberg A+ US Government/Credit Index, which focuses on U.S. Treasuries and other low-risk holdings. It is down more than 6% since the start of the year, but that’s less than half of the losses suffered by the S&P 500, which has slumped about 20%.


Core bonds have held up better than the equities market

Core bonds have held up better than the equities market. Indexed to 100 at the start of the year, the Bloomberg Intermediate A+ US Government/Credit Index has declined by 6.2%. The Bloomberg U.S. Aggregate Index has declined by 10.3%. Both have had better results than the S&P 500, which has declined by 20%. Source: Standard & Poor’s, Bloomberg. As of June 30, 2022.
Source: Standard & Poor’s, Bloomberg. Each index was indexed to 100 on January 1, 2022. As of July 1, 2022.

Another reason for optimism: a potential easing of the skimpy yields that have for years been a bane of bond investors. As older, lower-yielding bonds mature, portfolio managers are able to replace them with newer securities paying notably higher yields. That could ultimately benefit bondholders, as higher yields mean more income for the price.


We’re constantly getting interest payments into bond portfolios and reinvesting those at these higher rates,” Queen says.


An unusual confluence of challenges have hit in a brief span.


Until this year, bond yields had declined steadily for much of the past four decades. That was a double-edged sword for bond investors. On the one hand, falling interest rates on new securities boosted the value of older bonds. (If interest rates dip from, say, 3% to 2%, a security yielding 3% theoretically can be sold at a profit.) The result was that the total return on bond portfolios — which encompass coupon payments and capital gains — was lifted by the capital gains component. On the other hand, newer bonds generated successively less income, causing exasperation for investors seeking income generation.


A number of factors have pressured bonds recently. The ongoing COVID-19 pandemic, China’s clampdown on several high-profile industries and Russia’s invasion of Ukraine have caused enormous global upheaval. Though these factors differ in origin and effect, they all put upward pressure on inflation.


The risk of inflation hadn’t been top of mind for investors or policymakers for a very long time. In the U.S., the Consumer Price Index rarely hit the Fed’s desired 2% level through most of the 2010s. However, COVID-19 disruptions primed the pump by constraining the supply of goods. When lockdowns eased, consumers were flush with cash from government aid and eager to resume the patterns of normal life. The combination sent prices spiraling upward.


“In the U.S., the federal government put about five years’ worth of GDP growth into the economy,” Queen says. “We’ve had about a year of inflation as people tried to put that money back to work, but there aren’t enough workers, enough things to buy, enough planes to fly or enough hotel rooms.”


For bonds, inflation directly eats away at the value of coupon payments — an effect that’s magnified when interest rates are as low as they are today.


“We’ve had a steady increase in inflationary pressures,” Queen notes. “I think there’s a market recognition now that this inflation is real and that it features some structural components that could be longer lasting.”


That puts the Fed in a tough position. Powell recently said that taming inflation is the central bank’s top priority right now. But raising interest rates works by downshifting the economy. That forces the Fed to thread a difficult needle, Queen says: Does it raise interest rates enough to significantly slow the economy and run the risk of dampening demand too much? Or does it roll out rate hikes gradually to see if some structural issues work themselves out?


Bonds are well positioned for future changes.


Today’s higher yields have given the bond market more room to maneuver, Queen says. Higher yields directly translate into less sensitivity to changing interest rates, which should dampen volatility going forward.


“We’re watching high-quality corporate debt that has maintained its price,” Queen says. “We can sell those and buy bonds that we really like but have underperformed recently. When those trades make sense, they can give us a little more yield.”


In terms of positioning, Queen says he likes Treasury Inflation-Protected Securities, or TIPS, which pay out more as prices rise, because they offer some protection against higher inflation.


“I’m not all in on them, obviously,” he adds. “But they are an attractive component of a balanced portfolio. They help reduce our sensitivity to interest rates and diversify from typical Treasuries.”



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