Fixed Income Outlook: It’s Time to De-Risk Core Bond Portfolios | American Funds

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2018 outlook

Fixed Income Outlook: De-Risk Core Bond Portfolios

The global economic environment is improving. Growth is running modestly above trend across many countries and regions, a phenomenon that has not occurred in many years. We have to look to periods before the global financial crisis of 2007-08 to find an expansion this broad-based. However, fixed income markets may be too optimistic that these favorable conditions can continue for an extended period.

In our view, the global economy must continue to operate in this narrow band of “just right” to support current credit market valuations that remain elevated. Should growth momentum accelerate and break out above recent ranges, this would likely trigger more aggressive policy responses by global central banks. The resulting tighter monetary policy, delivered via higher policy rates and a faster withdrawal from quantitative easing, would likely hamper growth.


Key Takeaways

  • We expect U.S. interest rates to remain range-bound with the 10-Year Treasury yield hovering in the range of 2.25% to 3%.
  • Even as they tighten monetary policy, the bias of central banks remains supportive of economic growth. 
  • With inflation muted and growth rates modest, we expect the Fed will take a gradualist approach.
  • Municipal bonds continue to offer tax-advantaged income and diversification potential, but total return potential is likely to moderate and volatility could rise.
     

Amid Shifting Policy, Rates Should Remain Relatively Low Look for 10-Year Treasury Yields to Oscillate Between 2.25% and 3.0%

LI52 - Chart 1

Sources: Federal Reserve, Thomson Reuters. As of 9/30/17.

Long-term interest rates in the U.S. and much of the developed world remain at low levels. In the U.S., a number of factors have kept yields low, such as modest economic growth, persistently low inflation and strong demand from global investors for U.S. bonds. Long-term rates could rise modestly as U.S. economic growth remains robust and the Fed has started to trim its balance sheet, which means it will no longer be the largest buyer of bonds. Capital Group’s fixed income team expects the benchmark U.S. 10-Year Treasury yield to remain in a 2.25% to 3% range even though policy-driven rates are rising.

Despite the low level of yields on a historical basis, U.S. interest rates remain higher than many other developed markets, partly because the U.S. economy has sustained a significantly higher growth rate. The higher yields in the U.S. relative to other developed markets should continue to support demand for U.S. Treasuries. Meanwhile, against the backdrop of low interest rates in developed economies, demand for higher yielding emerging markets debt has risen substantially. The fixed income team expects this demand to continue.
 

Central Banks Take Gradual Approach to Tapering Financial Conditions Should Not Tighten Dramatically

LI52 - Chart 2

Sources: Capital Group, Thomson Reuters as of 9/30/17. European Central Bank (ECB), Bank of Japan (BOJ), Bank of England (BOE), U.S. Federal Reserve (Fed).

Since the financial crisis, central banks have expanded their balance sheets to unprecedented levels. These banks became the largest buyers of bonds and other securities as a way of increasing money supply to boost struggling economies. The four major central banks increased securities held on their books from around $4 trillion in 2007 to about $15 trillion in 2017. Now, as the global economy improves, some of them are beginning to move in the other direction. The Fed began shrinking its balance sheet in October. The European Central Bank signaled it will begin to trim its purchases of securities starting in January. With the Fed stepping away from its role as the largest buyer of securities, the risk of a modest rise in yields cannot be ruled out.

As financial conditions tighten, credit assets and mortgage-backed securities remain vulnerable. Investors should maintain a balance between interest rate and credit exposure. Within credit, consider moving up in credit quality so that portfolios can withstand a period of potential market volatility.
 

Fed Rate Hikes Don’t Have to Translate to Bond Losses In Periods of Rising Rates, Higher Income Can Help to Keep Returns Positive

LI52 - Chart 3

Sources: Bloomberg Index Services Ltd., Federal Reserve. Data through 9/30/17. Daily results for the index are not available prior to 1994. For those earlier periods, returns were calculated from the beginning of the month containing the first hike through the end of the month containing the final hike.

As the Fed continues on a path of gradually raising interest rates, many investors are moving to cash, short-term bonds and floating-rate securities. But the view that bonds have to suffer losses when short-term rates rise is a misconception. Looking at the past seven periods of interest rate hikes, including the current period, investment-grade bonds (BBB/Baa and above) have generally delivered positive returns, as can be seen from results for the Bloomberg Barclays U.S. Aggregate Index.

If rate hikes are gradual, interest earned by bonds can overcome the price impact to deliver a positive return. Indeed, since the Fed began on its current course of rate hikes, the index has gained nearly 6%, even as the Fed funds target has risen by 100 basis points. The Fed has signaled that it will maintain a gradual pace in raising rates and tightening monetary policy. Against this backdrop, interest rates will likely remain range bound.

Investment-grade and high-yield credit valuations continue to hover near historically tight levels not seen since the period before the 2007 financial crisis. In this market environment of range-bound long-term rates and tight credit spreads, investors should consider holding well-diversified core fixed income portfolios that do not take excessive credit risk. Credit-heavy strategies have performed well as stocks have soared, but they could suffer losses should stock markets reverse.
 

Seeking Diverse Income Potential? Consider Muni Bonds Attractive Tax-Advantaged Yields Make Municipals a Compelling Choice for Income Seekers

LI52 - Chart 4

Sources: Bloomberg Index Services Ltd. as of 10/31/17. Income from municipal bonds may be subject to state or local income taxes and/or the federal alternative minimum tax. Certain other income, as well as capital gain distributions, may be taxable. Methodology for calculation of taxable-equivalent yield: Based on 2017 federal tax rates. For the year 2017, there will be an Unearned Income Medicare Contribution Tax of 3.8% that applies to net investment income for taxpayers whose modified adjusted gross income exceeds $200,000 (for single filers) and $250,000 (for married filing jointly). Thus taxpayers in the highest tax bracket will face a combined 43.4% marginal tax rate on their investment income. The federal rates do not include an adjustment for the loss of personal exemptions and the phase-out of itemized deductions that are applicable to certain taxable income levels. Index proxies: municipal sectors from Bloomberg Barclays Municipal Bond Index; Bloomberg Barclays U.S. Aggregate Bond Index for U.S. taxable bonds.The indexes are unmanaged and, therefore, have no expenses. Investors cannot invest directly in indexes.

Municipal bonds are sometimes viewed as vulnerable amid rising interest rates. And yet, the past two years have shown that the asset class can provide solid returns when rate increases are modest and gradual - an environment that appears likely to persist. Also, demand for tax-advantaged income is unlikely to diminish. That said, valuations have been elevated. Greater emphasis on bonds of higher credit quality is one way investors can prepare for more mixed market conditions.

The asset class offers diverse income opportunities across sectors. For instance, toll roads are an area where research can uncover value by assessing prospects in a way that reflect risks associated with financing, operation and the regional economy. Consolidation among not-for-profit hospitals is creating great return potential. Look out for opportunities if uncertainty around the future of tax and health care reform prompts volatility and creates favorable entry points.

Municipal bonds offer a powerful combination of tax-advantaged income and equity-diversification potential. Consider higher quality issues when valuations are expensive. Investors comfortable with higher risk can also consider high-yield municipal bonds; they’ve tended to be significantly less correlated to equities than corporate high-yield bonds and have offered comparable average yields on an after-tax basis.

 

What This Means for Portfolios

Ensure your bond portfolio is broadly diversified and does not have excessive high-yield exposure. Invest selectively in credit. Don’t be afraid to have some duration. Consider small allocations to emerging markets bonds. Consider shifting a portion of core bond portfolios to municipal bonds. Go to our Portfolio Playbook for more detail.
 



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Content contained herein is not intended to serve as impartial investment or fiduciary advice. The content has been developed by Capital Group, which receives fees for managing, distributing and/or servicing its investments.

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