Major shifts in central bank policy made 2022 a difficult year for bond markets. While uncertainty about interest rates and inflation persisted into the first quarter of 2023, the outlook on bonds has improved. For investors, this means bond funds are once again offering relative stability in an environment where traditional portfolio allocation strategies have struggled to replicate their historical performance.
Analysts at Capital Group, an American investment manager with over $2.6 trillion in assets, believe that trends in inflation hold the key to unlocking the value of high-quality bonds.
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Peak Inflation a Welcome Sign for Bond Investors
On April 12, the Department of Labor reported that U.S. inflation eased in March to its lowest level in nearly two years. The consumer price index (CPI), the broadest measure of inflation, rose 5% year-over-year, down from February’s 6% increase and the lowest level since May 2021. Although core prices rose slightly, the underlying trend shows inflation continuing to moderate from its mid-2022 peak.
With peak inflation likely behind us, the Federal Reserve is expected to adopt a more moderate stance on monetary policy. The Fed hiked interest rates aggressively in 2022 to combat inflation, but it has since moderated its tone—and the size of its rate adjustments. This should be a welcome sign for investors.
“Once the Fed pivots from its ultra-hawkish monetary policy stance, high-quality bonds should again offer relative stability and greater income,” said Pramod Atluri, a fixed-income portfolio manager at Capital Group. Although a decelerating economy will likely accompany slowing inflation, this environment could be a boon for high-quality fixed income by lowering yields and raising bond prices.
Capital Group’s analysts further showed that investing six months before the Fed’s final rate hike has historically provided strong returns going all the way back to 1981. “Bonds now offer a much healthier income stream, which should help offset any price declines,” Alturi added.
While anticipating the Fed’s next move is never easy, Federal Open Market Committee (FOMC) members have marked an endpoint range of 5% to 5.25% for the federal funds rate. As of March, the Fed’s so-called ‘dot-plot’ chart showed only one more rate hike this year.
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An Attractive Entry Point for Investors
Bond yields across all major asset classes have soared from their pandemic lows, leading Capital Group’s analysts to conclude that “income is back in fixed income.”
From trough to peak, the yields on the U.S. Aggregate Index, investment-grade U.S. corporates, high-yield U.S. corporates, emerging market debt, and the 10-year Government of Canada bond rose between 2.53 points and 5.10 points from 2020 to November 2022. Although bond yields have declined from their recent peaks, today’s starting yields provide an “attractive entry point for investors,” especially those looking to cushion against expected volatility and the possibility of recession.
The big question, according to Capital Group, is whether investors should use this opportunity to diversify into riskier corporate or high-yield bonds. Corporate balance sheets remain in good shape for now, but are more vulnerable to cyclical or economic downturns. That being said, insights from T. Rowe Price suggest that corporate default risks due to recession are largely overblown. Of course, that risk assessment could change as a slowing economy erodes consumer spending.
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