Bonds

4 high-income seeking investment strategies for a high-rate world

Things are looking up for bond markets. As yields rise, the potential for income is the highest in more than two decades, and volatility tied to interest rate increases may decline as the Federal Reserve nears the end of its rate-hiking campaign. Through it all, the U.S. economy has surprised to the upside.

 

In an ideal world, achieving high income against this backdrop would be as easy as parking cash in relatively low risk money market funds and hoping it grows. The reality is more nuanced: Rates are likely to fall from here, so it’s unrealistic to expect returns from cash and cash-like investments to stay at current levels long term.

Investors have flocked to cash, driving up money market fund holdings

Sources: Capital Group, Bloomberg Index Services Ltd., Investment Company Institute (ICI). Data as of August 11, 2023. While money market funds seek to maintain a net asset value of $1.00 per share, they are not guaranteed by the Federal Deposit Insurance Corporation or any other government agency. You could lose money by investing in money market funds.

In fact, the return potential for the record $5.5 trillion sitting in money market funds will likely decline as inflation falls and the Fed concludes its rate increases. The jury is out on just how quickly or when exactly rates will fall, but bonds have historically seen returns above cash and cash-like investments in the years following a peak in the Fed funds rate.

 

Although the outlook is rosier, the economy is not out of the woods as rate increases continue to impose much higher borrowing costs on companies and consumers.

 

Against this backdrop, Damien McCann, principal investment officer for American Funds® Multi-Sector Income Fund, and David Daigle, principal investment officer for American High-Income Trust®, offer their thoughts on compelling investment opportunities as the economy and the Fed near a pivotal phase.

1. Seek to capture attractive yields before rates fall

 

Yields soared and bond prices tumbled in 2022 as elevated and persistent inflation pushed the Fed to raise rates at a breakneck pace. So far in 2023, volatility hasn’t been nearly as dramatic, but stubborn inflation has pressured the central bank to continue with more gradual rate increases.

 

More recently, the yield on the 10-year Treasury, which underpins borrowing costs for much of the economy, hit 4.35% in August, the highest level since 2007. And while the month-long volatility has been tough on bond markets, elevated long-term rates should ultimately dampen inflationary pressures.

 

Despite lingering uncertainties about the economy, one thing is clear: The rise in rates created many paths to strong income and return potential in bond markets.

 

That’s because starting yields have been a good indicator of long-term return expectations. The Bloomberg U.S. Aggregate Index, a widely used benchmark for investment-grade bonds (rated BBB/Baa and above), yielded 4.93% as of August 25, 2023. That figure is well above the index’s yield of 1.70% on December 31, 2021, prior to the start of the Fed hiking cycle. The Bloomberg U.S. Corporate High Yield Index, a broad representation of high-yield bonds, yielded 8.48% as of August 25, 2023, versus its yield of 4.41% on December 31, 2021.

Strong income potential may persist as yields stabilize at elevated levels

Sources: Bloomberg Index Services Ltd., RIMES. Data shown from July 31, 2013, to August 25, 2023. Sector yields above include U.S. aggregate represented by the Bloomberg U.S. Aggregate Index, investment-grade corporates represented by the Bloomberg U.S. Corporate Investment Grade Index, high-yield corporates represented by the Bloomberg U.S. Corporate High Yield Index and emerging markets debt represented by the 50% J.P. Morgan EMBI Global Diversified Index/50% J.P. Morgan GBI-EM Global Diversified Index blend. Past results are not predictive of results in future periods.

“Getting here has been painful, but bonds now offer fantastic income potential,” McCann says. A strategic allocation to higher income sectors can help boost long-term return potential, with lower volatility than equities, which is an important consideration for income-seeking investors. Higher income seeking sectors include corporate investment-grade and high-yield bonds, emerging markets debt and securitized debt.

 

“If inflation continues to ease and economic growth remains sluggish, rates will likely decline somewhat from here, while remaining higher than investors have become accustomed to in recent years,” McCann notes. In that context, fixed income sectors may be attractive since bond prices rise when yields fall. And since the total return of a bond fund consists of income and price changes, “falling yields would be a tailwind for returns on top of the hefty coupon payments from bonds,” he adds.

 

The surest path to falling yields — and potential price appreciation — is via rate cuts by the Fed. That could happen if inflation continues to fall, the economy enters a significant downturn, or central banks seek a “neutral” policy rate that neither restricts nor stimulates economic growth, according to Daigle. Falling Treasury yields would help offset the negative impact of wider credit spreads, or the incremental yields that bonds typically pay over Treasuries.

2. Consider investment-grade bonds while fundamentals are strong

 

The recession that was supposed to be here by now appears to be on hold. To be sure, there are weaknesses in various parts of the economy but even areas sensitive to rising rates, such as housing, may be stabilizing.

 

“Consumers continue to power the economy,” McCann says, “and while there has been some softening, trends remain encouraging with firm labor markets and steady consumer spending for leisure and travel activities.”

 

Delinquencies for credit cards edged higher in the second quarter compared to the first three months of the year, but are not worse than pre-pandemic normalized levels, according to an August 2023 report from the Federal Reserve Bank of New York.

 

Many companies have been able to pass on costs to consumers, which has bolstered corporate fundamentals, including profits. These companies have also worked to reduce operating expenses and are managing their cash conservatively.

 

“That strategy should allow these companies to continue to refinance or repay their debt as earnings growth slows or contracts in a downturn,” McCann says.

 

More opportunities are emerging across industries in investment-grade bonds. One area of potential value is large money center banks, where spreads are well above historic averages and the credit quality is excellent. “Recent troubles in the banking sector seem to be contained, and while banks overall have dialed back on lending, the contraction hasn’t yet been severe enough to push the economy into a recession,” McCann adds.

3. Look to high-yield bonds where stars appear aligned

 

For investors with a time horizon of at least a year, some risks may appear worth taking.

 

So far this year, starting yields of around 8% have provided a buffer against bond market volatility tied to the Fed’s rate path. That in turn has helped support solid returns for the year-to-date period ended August 29, 2023, with the Bloomberg U.S. Corporate High Yield Index posting a 6.81% gain.

 

“Many companies in the high-yield market have adapted fairly easily to higher rates,” Daigle says. For example, several companies have paid down debt, thereby reducing interest expense. Lower leverage and improved operations have increased the number of “rising stars,” or companies that have been upgraded out of high-yield territory. According to Daigle, that trend is likely to continue.

The stars are rising for high yield companies

Source: Capital Group, J.P. Morgan Global Research. As of August 5, 2023.

One challenge ahead is the potential consequence of high borrowing costs on companies. At some point, higher rates may lead to weaker credit profiles and lower valuations. “This process could be gradual rather than abrupt and investing in high-yield bonds today may help offset future volatility associated with a slowdown,” Daigle says.

 

Any issuer facing a combination of higher funding costs and deteriorating earnings will likely have a difficult time refinancing its debt, underscoring the importance of a selective investment strategy. “This is not really an industry-level phenomenon,” Daigle concludes, “although there are issuers within the communications sector that appear particularly exposed.”

4. Diversify your income investments

 

A common investment strategy applies, even when rates are this elevated: diversify your holdings.

 

For income-seeking investors, this includes investing across bond sectors that have been hard hit, such as emerging markets and securitized debt. Returns across investment grade, high yield, emerging markets and securitized debt vary over time. McCann believes a diversified, multisector approach can help investors navigate headwinds that impact parts of the economy unevenly.

 

Several countries are having a tough time in this high interest rate, slow growth environment, but the net is wide in emerging markets and many issuers have been able to navigate these circumstances, according to McCann. For example, Oman has benefited from higher oil prices. Additionally, Latin American countries proactively lifted rates well before major central banks, which helped insulate economies by easing inflation and currency pressures.

 

Meanwhile, the securitized space has been especially volatile over the last 18 months, led by weaknesses in commercial mortgage-backed securities (CMBS) and concerns that office vacancies may remain high given work from home trends.

 

“For the funds I manage, I am starting to tiptoe back into high-quality CMBS,” McCann says. The relatively strong consumer also points to opportunities in asset-backed securities such as those backed by car rentals and subprime auto loans.

 

As markets continue to react to Fed moves, inflation and shifting narratives about the economy, investors should focus on long-term financial goals.

 

“You can’t predict the future, so I always advocate for both a multisector approach and a long-term perspective,” McCann concludes. “I’m optimistic as rate hikes have set the stage for much stronger income and return from bonds in the years ahead.”

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.

David Daigle

David Daigle is a fixed income portfolio manager with 29 years of investment industry experience (as of 12/31/2023). He serves as the principal investment officer of American High-Income Trust®. He holds an MBA from the University of Chicago and a bachelor’s degree in business administration from the University of Vermont.

Investing outside the United States involves risks, such as currency fluctuations, periods of illiquidity and price volatility, as more fully described in the prospectus. These risks may be heightened in connection with investments in developing countries.
 

The return of principal for bond funds and for funds with significant underlying bond holdings is not guaranteed. Fund shares are subject to the same interest rate, inflation and credit risks associated with the underlying bond holdings. Lower rated bonds are subject to greater fluctuations in value and risk of loss of income and principal than higher rated bonds. 
 

The indexes are unmanaged and, therefore, have no expenses. Investors cannot invest directly in an index.
 

Bloomberg U.S. Aggregate Index represents the U.S. investment-grade fixed-rate bond market.
 

Bloomberg U.S. Corporate Investment Grade Index represents the universe of investment-grade, publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specific maturity, liquidity and quality requirements.
 

Bloomberg U.S. Corporate High Yield Index covers the universe of fixed-rate, non-investment-grade debt.
 

J.P. Morgan Emerging Market Bond Index (EMBI) Global Diversified is a uniquely weighted emerging market debt benchmark that tracks total returns for U.S. dollar-denominated bonds issued by emerging market sovereign and quasi-sovereign entities. J.P. Morgan Government Bond Index — Emerging Markets (GBI-EM) Global Diversified covers the universe of regularly traded, liquid fixed-rate, domestic currency emerging market government bonds to which international investors can gain exposure. The 50%/50% J.P. Morgan EMBI Global/J.P. Morgan GBI-EM Global Diversified Index blends the J.P. Morgan EMBI Global Index with the J.P. Morgan GBI-EM Global Diversified Index by weighting their cumulative total returns at 50% each. This assumes the blend is rebalanced monthly.
 

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