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BONDS

Investing for income as rates rise

Damien McCann Kirstie Spence Xavier Goss

May 4, 2022

Markets are on edge over soaring consumer prices, the war in Ukraine and recession fears in the U.S., Europe and China.

 

The Bloomberg U.S. Aggregate Index, a broad representation of the U.S. bond market, declined 5.9% in the first quarter, the worst quarterly loss since 1980. In April, it was down another 3.8%. With bond returns battered, investors may be wondering if there are any bargains in fixed income markets. Given the low prices, is now a good time to buy?

 

The risks are real. The U.S. Federal Reserve’s efforts to contain inflation are likely to pressure growth and employment. This week, the Fed raised its key policy rate 50 basis points to 0.75%–1.00%, the largest increase since May 2000.

Rate hike expectations have jumped

The chart shows that the market and the U.S. Federal Reserve have dramatically shifted their rate hike expectations since December 2021. On April 28, 2022, the market expected the federal funds rate at year-end 2022 to be at 2.73% versus expectations in December of 0.76%. The rate would move higher by year-end 2023 to 3.26% versus prior expectations of 1.37%, and year-end 2024 to 2.94% versus prior expectations of 1.58%. By comparison, the Fed’s dot plot in March 2022 showed the rate at year-end 2022 was expected to be around 1.88% versus prior expectations in December 2021 of 0.88%. The rate would move higher to 2.75% versus prior expectations of 1.63% at year-end 2023, then 2.75% versus prior expectations of 2.13% at year-end 2024, and 2.38% versus prior expectations of 2.50% longer term.

Sources: Bloomberg, Federal Open Market Committee. Projections assume rate at year-end.

And as Europe seeks to wean itself from Russian oil and gas, energy prices — up 38% year-to-date — may remain elevated.

 

Against this challenging backdrop, portfolio managers with American Funds Multi-Sector Income FundSM  offer their views about what’s ahead for some of the riskier bond market sectors.

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Companies are benefiting from consumer demand, but expect a more volatile environment for credit

Damien McCann, fixed income portfolio manager

The Fed seems intent on trying to slow economic activity. Rate hikes tend to impact economic activity with a lag of at least two quarters. Right now, corporate fundamentals are fairly strong, and companies are benefiting from a consumer that is able to withstand price increases. I am seeing early indications that lower income consumers are spending less, but overall, there is no significant pullback.

 

Inflation is a major concern, and Russia’s invasion of Ukraine has only added fuel to the fire. The economic toll of the invasion has far-reaching effects that are not yet fully visible. Obviously there has been an impact on the energy and grain sectors, but it has also spilled into certain parts of auto manufacturing and industrial gasses the semiconductor industry relies on.

 

Food and autos are more exposed to higher input costs and shortages compared to telecom and cable, or health care companies.

 

Spreads have widened over the past year, and it is a more volatile environment for credit. The issuance of high-yield bonds has dropped dramatically as companies wait for things to settle down.

Corporate bond spreads have widened ahead of slower economic growth

The line graph shows option-adjusted spread in basis points for both investment-grade and high-yield bonds from March 2021 until April 2022. Spreads have increased from March 31, 2021, of 90.5 basis points for investment-grade bonds and 311 basis points for high-yield bonds to the April 29, 2022, spreads of 135 basis points and 379 basis points for investment-grade and high-yield bonds, respectively.

Sources: Bloomberg Index Services Ltd., RIMES. As of 4/30/22. Chart reflects option-adjusted spreads. 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 fund's investment policies.

As an active manager, I have the flexibility to react to these ongoing shifts.

 

The returns across investment grade, high yield, emerging markets and securitized debt are not the same over time. Being flexible and adjusting your portfolio can help buffer some of the current headwinds. There have been more opportunities in investment-grade bonds over the past few months, but I still think high-yield bonds offer better value.

 

Within investment-grade corporates, certain California-based utilities seem attractive. In high yield, energy companies have some upside. In my view, oil prices will stay fairly high as supply is likely to remain tight. Beyond Russia, U.S. energy companies have a labor shortage problem which will limit increases in drilling activity. People in West Texas can work remotely and earn the same wage as if they were working on an oil rig.

 

Among high-yield credits, I also see value in insurance brokerage and financial advisory issuers. These are resilient business models that can withstand high leverage.

Valuations and fundamentals suggest cautious optimism for emerging markets

Kirstie Spence, fixed income portfolio manager

What’s happening in Ukraine is heartbreaking. I’ve dealt with many crises in my 25-plus years of investing in emerging markets, and this one is uncharted territory on so many levels.

 

I think it’s prudent to stay cautious given the heightened volatility from war, inflation and the slowdown in China. However, there are idiosyncratic opportunities in emerging markets debt that an active manager can pursue.

 

Bonds across many emerging markets have traded lower, but some of that trading has been related to risks tied to inflation and what central banks are doing. The asset class has matured significantly over the past decade. I think valuations generally reflect some downside risks.

 

Overall, fundamentals are fairly decent. Several emerging markets banks have raised rates dramatically to combat inflation. And in some markets like Brazil, investors are being fairly compensated for elevated inflation. I also think certain currencies may even be cheap by historical standards.

 

There are bright spots. Commodity exporters such as certain Latin American-based countries have traded higher, as surging prices could help them withstand a slowdown in global growth.

Proactive rate hikes could provide attractive entry points for some emerging markets

The chart above shows the interest rates for several emerging market countries on December 31, 2020, and April 30, 2022. A third column shows the change between the two dates. In general, many countries have hiked rates including Brazil with the highest change of 9.75% in rates to the April 30, 2022, rate of 11.75% versus the December 31, 2020, rate of 2.00%. Chile had a 6.50% change in rates to 7.00% on April 30, 2022, versus 0.50% on December 31, 2020. Peru had a 4.25% change in rates to 4.50% on April 30, 2022, versus 0.25% on December 31, 2020. Columbia had a 4.25% change in rates to 6.00% on April 30, 2022, versus 1.75% on December 31, 2020. Mexico had a 2.50% change in rates to 6.50% on April 30, 2022, versus 4.00% on December 31, 2020. Czech Republic had a 4.75% change in rates to 5.00% on April 30, 2022, versus 0.25% on December 31, 2020. Poland had a 4.40% change in rates to 4.50% on April 30, 2022, versus 0.10% on December 31, 2020. Hungary had a 4.80% change in rates to 5.40% on April 30, 2022, versus 0.60% on December 31, 2020. Romania had the smallest change of 1.75% to 3.00% on April 30, 2022, from 1.25% on December 31, 2020.

Source: Bloomberg. Data shown as of 4/30/2022.

Securitized assets may be more resilient compared to other bond sectors as inflation and rates rise

Xavier Goss, fixed income portfolio manager

Securitized assets cover a wide gamut of sectors such as residential mortgages, auto loans, commercial real estate and student loans. Broadly speaking, asset-backed securities and commercial mortgaged-back securities have some upside even with higher inflation. Select areas appear attractive compared to corporate credit, particularly at current spread levels.

 

I remain a bit cautious as tighter monetary policy will slow growth and loan demand. That will flow through and impact consumer spending. I expect an uptick in delinquencies and defaults as eviction moratoriums and other pandemic-era programs roll off. While the increase could be higher than pre-pandemic levels, it shouldn’t be exceptionally so because consumers are in a better financial position today as compared to past financial crises.

Consumers may be better prepared to weather an economic slowdown

The bar chart above shows the cumulative personal savings levels at the start of prior recessions versus today. The current March 2022 level of $1.2 trillion dollars is higher compared to the $361 billion of the early 1990s recession, the $392 billion of the Dot-com Bubble in March 2001 and the $321 billion of the Great Recession in December 2007 and similar to the December 2019 COVID recession.

Sources: Capital Group, Federal Reserve Bank of St. Louis, National Bureau of Economic Analysis, Refinitiv Datastream. Personal savings figures are seasonally adjusted and released quarterly. All prices shown in USD.

I have been spending more time meeting with loan originators to better understand their specific underwriting standards. As financial conditions tighten, there may be a bifurcation in deal performance as weaker originators loosen their underwriting standards to maintain current loan volume.

 

In the current environment, I foresee more bespoke and privately negotiated transactions across the securitized space, particularly as security selection becomes a more prominent driver of returns. This is especially relevant in the consumer asset-backed securities market where there are more niche issuers.

Read important disclosures

damien-mccann-color-600x600

Damien J. McCann is a fixed income portfolio manager with 24 years of investment industry experience (as of 12/31/2023). 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.

kirstie-spence-color-new-600x600

Kirstie Spence is a fixed income portfolio manager with 28 years of investment industry experience (as of 12/31/2023). She is the principal investment officer for the Capital Group Emerging Markets Local Currency Debt LUX Fund and serves on the Capital Group Management Committee. She holds a master's degree with honors in German and international relations from the University of St Andrews, Scotland.

XVG

Xavier Goss is a portfolio manager with 20 years of investment industry experience (as of 12/31/2023). He holds a bachelor's degree from Harvard. He also holds the Chartered Financial Analyst® designation.

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