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Capital IdeasTM

Investment insights from Capital Group

Categories
Market Volatility
When short term pain can bring long term gains
Flavio Carpenzano
Investment Director
October 6, 2022
KEY TAKEAWAYS
  • The extent of the sell-off in fixed income markets has been both large and rare relative to history, with returns across bond markets hitting historical lows. 
  • Aggressive rate hikes by central banks have led to higher starting yields, creating an attractive entry point for investors.
  • Emerging market local currency bonds could offer value given high real yield differentials.
  • The shorter duration of the high-yield market means it is less sensitive to the higher interest rates that we are experiencing alongside higher inflation and monetary policy normalisation.

2022 has not been a great time for bonds. Year-to-date, the Bloomberg Global Aggregate Index and Bloomberg US Treasury Index returned -20% and -13%, respectively1.  Meanwhile, risky asset classes also sold off significantly, which has led to many investors questioning the role of bonds as a diversifier to equities. 


While we acknowledge the frustration and the stress investors face in such a volatile market environment, it is important to avoid acting on impulse. Instead, investors should reflect on recent events to understand what has caused this massive drawdown in markets and then act accordingly by positioning their portfolios for the current economic backdrop. As always, it is important to take a long term view.


Return distribution of US Treasuries since 1973

Past results are not a guarantee of future results.
Return distribution of the Bloomberg US Treasury Index from 31 December 1973 to 30 September 2022. Based on monthly data. Source: Bloomberg

Reflect: understand what has happened so far


Bond markets were affected by a sharp and rapid increase in interest rates, triggered by increasingly hawkish developed market central banks, whose priority suddenly shifted to fight multi-decade high inflation levels.  


However, the extent to which bonds are impacted by an increase in interest rates depends on three main factors: 1) the magnitude of the increase, 2) the speed of the increase and 3) the starting level of yields. The slower the pace of rate hikes, the more income fixed income assets can accrue to offset the loss from rising rates. For example, during the 2015 to 2018 rate-hiking cycle, it took a year before the Fed undertook its second hike and a total of 36 months for rates to be hiked by 225 bps2.


On the contrary, 2022 has been the perfect storm for fixed income markets where all the three factors mentioned above represented a headwind. To put it into perspective, since the beginning of the year, the yield on the US 


2-year Treasury – used as proxy for expected future Fed hikes – has increased 1) significantly (354bps), 2) rapidly (in only 9 months) and 3) from a very low starting yield (only 0.73%)3. As a result, fixed income assets were unable to accumulate sufficient income to help cushion the losses from rising rates. The combination of these three factors has been the main reason for the extreme market to market losses bonds have experienced so far this year.


Act: look forward and have a long term view 


While the Fed’s current hiking cycle remains uncertain, current bond prices already anticipate most of the increase. Looking at the Bloomberg Global Aggregate Index, the percentage of negative yielding assets has fallen from 16.5% at the end of 2021 to 7.8% at the end of September 20224. At this point, the market has priced in a significant number of short-term rate increases in the coming months and longer dated US Treasury yields (e.g. 10-year) already reflect that. In fact, forward rates suggest relatively limited moves on longer dated yields in the next year, which should lessen the negative impact on bonds. 


Today’s starting yields also offer an attractive entry point for investors. Yields across fixed income sectors are sharply higher than their lows over the past few years. For example, high quality global investment grade corporate bonds currently offer a yield of 5.4%, which is higher than the 4.1% yield that was offered by global high yield corporate bonds during their recent lows in 20215. At current yields, history suggests higher total returns over the next few years. This means that investors could benefit from holding bonds across fixed income asset classes, including high yield. This higher income can offer more of a cushion for total returns over time, even if price movements remain volatile. 


Higher yields have boosted total returns

Past results are not a guarantee of future results.
Yields and returns as at 30 September 2022 in USD terms. Data goes back to 2000 for all sectors except for emerging markets debt, which goes back to 2003. Based on average monthly returns for each sector when in a +/- 0.30% range of yield-to-worst. Sector yields above include Bloomberg Global Aggregate Index, Bloomberg Global Aggregate Corporate Index, Bloomberg Global High Yield Index, 50% J.P. Morgan EMBI Global Diversified Index / 50% J.P. Morgan GBI-EM Global Diversified Index blend. Sources: Capital Group, Bloomberg.

 


1. As at 30 September 2022. Source: Bloomberg 


2. Source: Bloomberg 


3. As at 30 September 2022. Source: Bloomberg 


4. As at September 2022. Source: Bloomberg 


5. Current yield as at 30 September 2022. Date of recent low is 6 July 2021. Source: Bloomberg


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. 

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Market Volatility
Bonds
Fixed Income
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