By Chris Miles, head of financial intermediaries at Capital Group
As bond yields rise, the potential for income is at its highest in more than two decades and the volatility tied to interest rate hikes may decline as the US Federal Reserve nears the end of its rate-hiking campaign.
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, however, is more nuanced. Rates are likely to fall from here, so it is unrealistic to expect returns from cash and cash-like investments to stay at current levels long term.
In fact, the return potential for the record £4.5trn 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.
See also: ‘Unsustainable’ US debt: Could the Fed consider cutting interest rates?
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. Yet compelling investment opportunities remain for those seeking high income as central banks near a pivotal phase.
1. Capture attractive yields before rates fall
Yields soared and bond prices tumbled in 2022 as persistent inflation pushed the Fed to raise rates at a breakneck pace. Volatility was not nearly as dramatic in 2023, but stubborn inflation has pressured central banks to continue with more gradual rate increases.
Despite lingering uncertainties about the economy, one thing is clear – rate rises have 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 US Aggregate index, for example, yielded 4.93% as of August 2023. That figure is well above the index’s yield of 1.7% in December 2021, prior to the start of the Fed hiking cycle.
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.
If inflation continues to ease and economic growth remains sluggish, rates could decline while still remaining higher than investors have become accustomed to. In that context, fixed income may be attractive seeing as bond prices rise when yields fall. And since the total return of a bond fund consists of income and price changes, those falling yields could be a tailwind for returns on top of the hefty coupon payments from bonds.
2. Consider investment-grade bonds while fundamentals are strong
The recession that was supposed to be here by now appears to be on hold. There are weaknesses in various parts of the economy to be sure, but even areas sensitive to rising rates such as housing may be stabilising.
Consumers continue to power the economy and while there has been some softening, trends remain encouraging with firm labour markets and steady consumer spending for leisure and travel activities.
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.
More opportunities are emerging across industries in investment-grade bonds. One area of potential value is large money centre banks, where spreads are well above historic averages and the credit quality is excellent.
3. Look to high-yield bonds where the stars have aligned
The quality of the high-yield bond market has increased significantly in recent decades. BB rated companies – the highest quality of high yield issuer – now represent around half of the market. The pandemic saw an acceleration of this trend, and many of the weaker credits with challenged business models have left indices after becoming bankrupt.
In the current credit cycle, much of the riskier lending has taken place in the leveraged loan market and private credit. High-yield issuers in public markets have tended to be more prudent and have taken advantage of low interest rates to lock in low borrowing costs and push out the maturity of their debt. This should help contain high yield default rates in the next couple of years.
An allocation to high yield may be compelling as we approach the end of the current hiking cycle, particularly for investors seeking income who have chosen to sit in cash to ride out the past year’s volatility.
4. Diversify your income investments
A common investment strategy perseveres 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. A diversified, multi-sector 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. For example, Latin American countries proactively lifted rates well before major central banks, which helped insulate their economies by easing inflation and currency pressures. This has enabled some to now start cutting rates.
As markets continue to react to Fed moves, inflation and shifting narratives about the economy, investors should focus on long-term financial goals and a multisector approach is key to securing stronger income and returns.
