Multi-sector income: Investing for income as rates rise

by Damien J. McCann, Kirstie Spence, and Xavier Goss, Capital Group

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 Bond Index, a broad representation of the U.S. bond market, declined 5.9% in U.S. dollars 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 in the near term as its outlook remains hawkish.

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, three of our fixed income portfolio managers with Capital Group Multi-Sector Income FundTM (Canada) offer their views about what’s ahead for some of the riskier bond market sectors. (Multi-Sector Income is available to investors as of June 30, 2022.)

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.

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 labour 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 U.S. 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 in the U.S. 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 US$1.2 trillion dollars is higher compared to the US$361 billion of the early 1990s recession, the US$392 billion of the Dot-com Bubble in March 2001 and the US$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.

Damien J. McCann is a fixed income portfolio manager with 22 years of industry experience (as of 12/31/2021). 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 is a fixed income portfolio manager who specializes in emerging markets debt. She has 26 years of investment experience (as of 12/31/2021) and holds a master's degree with honors in German and international relations from the University of St. Andrews, Scotland.

Xavier Goss is a portfolio manager with 18 years of investment industry experience (as of 12/31/2021). He holds a bachelor's degree in economics from Harvard. He also holds the Chartered Financial Analyst® designation.

Copyright © Capital Group

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