Investment grade bonds often produce some of their best performance in the three years after the last rate hike in a cycle. We speak to Capital Group’s Haran Karunakaran about the implications for investors.
For a long time bonds have been the anchor point of investment portfolios. Providing reliable and stable yields, they have been the key asset to offset the often chaotic return pattern of equities.
But last year was one of the worst years for bond investors on record.
For example, the return on a 30-year US government bond was minus 39 per cent, a level of negative performance not seen since the 18th century. Even broad investment grade bond indices lost well over 10 per cent in 2022.
The reason for this disappointing performance is clear. Never before has the world seen a rate tightening cycle as aggressive as last year’s, as central banks frantically tried to catch up to a rise in inflation that was initially seen as transient.
But there are now indications that we are nearing the end of the tightening cycle and investors could see the first rate cuts filtering through next year.
“Even without a recession, you could well see central banks cutting rates, because real rates are getting more restrictive as inflation comes down,” Haran Karunakaran, Investment Director at Capital Group, says in an interview with [i3] Insights.
Even without a recession, you could well see central banks cutting rates, because real rates are getting more restrictive as inflation comes down
“If you think in inflation adjusted terms, with the Fed funds rate at 5.5 per cent, subtract 3.5 per cent inflation today and the result is a 2 per cent real rate.
“If inflation falls to 2.5 per cent and the Fed funds rate stays where it is, the real rate actually goes up by 100 basis points. So, we are in this unusual scenario where the Fed being on hold can actually result in a tightening impulse,” he says.
Although we might see another one or two rate increases from central banks, it is increasingly clear we are approaching peak rates. Karunakaran believes that this means the time to get back into bonds is now, especially investment grade bonds.
“The most important for fixed income investors today is the high starting yield. Global investment grade corporates yield six per cent. That starting point makes it very hard to have a really negative outcome,” he says.
“That six percent will be a buffer against mark-to-market price volatility. And that’s the big difference between today and 2022. In 2022, when we had that sell-off, there was no income buffer,” he says.
One of the key risks to the 2024-25 rate cut scenario is if a sudden acceleration of inflation, occurs. This would force central banks to further increase rates. Although interest rates are already considered high, they are modest compared to the 1980s.
On 5 December 1980, the Federal Reserve increased the target level by two percentage points to 19 – 20 per cent, the highest level ever seen, as inflation clocked in well over 14 per cent.
But Karunakaran estimates that the odds are low for such a scenario today.
“The real worry of central banks is when it comes down to a classic wage price spiral, where people are expecting inflation, so they demand more wages and it goes in a bad cycle like that,” he says.
“But I think if anything, what we’re seeing is signs going in the opposite direction of the labour market, still strong, but showing signs of softening a bit. This is of course something we are watching closely, but we see it as more of a risk scenario than a base case”.
Karunakaran is also somewhat cynical about market projections on the prospects of a hard landing, or a soft landing for that matter.
The real worry of central banks is when it comes down to a classic wage price spiral, where people are expecting inflation, so they demand more wages and it goes in a bad cycle like that
He points out that in the first half of 2023 the market consensus was that the US was “definitely going into a recession”, yet that never eventuated. Now many market watchers have flipped to the other extreme, embracing the “soft/no landing” narrative.
Karunakaran says rather than making pinpoint economic projections, the more important thing is to understand which risks have been priced into particular assets.
“We’re in this uncertain environment, where it’s almost as if it doesn’t matter whether your baseline is recession or no recession, because what matters more is whether you’re being compensated for the risk you’re taking. In many of the higher risk parts [of the market], that’s not happening at the moment,” he says.
Karunakaran sees the current valuations of high yield bonds as particularly rich, but he is positive on investment grade assets, although at the index level they are also starting to look a bit expensive.
“If you look underneath the surface, there’s actually quite a lot of dispersion between individual bonds,” he says.
“In the global investment grade markets today, you have an average spread level of 135 basis points, but about a third of the index is trading at over 150 basis points which is attractive.
“On the flip side, you have about a third trading under 100 basis points. So that’s quite tight and an area where you want to be careful. You’re not getting compensated for anything going wrong there. Selectivity is crucial. It’s not the sort of market environment where you should just buy the index,” he says.
Steady Cash Flows
Although Karunakaran advocates a bottom-up approach in the current market environment, there are some common themes that offer interesting opportunities for institutional investors.
The banking sector is one of them.
After the global financial crisis, regulation and control of banks changed significantly, as risk controls and capital requirements were tightened. The management approach of banks has changed too, resulting in a retreat from the riskier businesses and towards more plain vanilla, deposit-taking and lending operations.
“It was almost as if banks went from financial engineering firms to more utility-like, steady cash flow businesses,” Karunakaran says.
The US regional bank disturbance in March this year then created an opportunity to invest in some of the larger, more stable banks in the country.
“You just saw a real widening in bank bond spreads, and it was pretty indiscriminate. It wasn’t just the banks that were similar to the US regional banks that were selling off, it was across the board,” he says.
“That created a lot of opportunities for us to go in and focus on the banks that look quite different to the regional banks.
“We tended to focus on the large global banks, the big money centre banks in the US. These are banks with much stronger balance sheets, more effective risk controls in how they do their asset liability matching, diversified business lines, much stickier deposit bases.
“So all of the risks that we saw in the regional banks were not really there,” he says.
And it wasn’t just banks. Other companies with similarly stable cash flow profiles also caught the eye of Karunakaran.
“Businesses with subscription-like revenue models are particularly attractive. For example, asset management firms, wealth management firms and insurance companies, all of which have steady, on-going revenue streams from their customers,” he says.
“We are looking for those sorts of companies with very steady cash flows, companies which will be less impacted through a recession. Pharmaceuticals and defence-related industries form another common example of sectors that are a bit more recession proof.”
The Risk of Cash
Investors that stay in cash might get themselves into trouble. Capital Group has conducted research on rate hiking cycles and looked at the behaviour of markets in the months after the last rate hike.
The study included 50 years of data and covered five interest rate cycles. Although each cycle was different, Karunakaran says it also showed some consistent and very interesting patterns.
“One of the patterns you see is that within about 12 months after the last hike, short-end rates and bond yields start to come down,” he says.
“The implication for investors here is that anything that is cash-like, whether it’s term deposits, money market funds, or floating rate bonds, the yield on those will decay quite significantly.
“On average over these cycles, we found that the yield on money market funds by 2.2 per cent within 18 months of the last hike in a cycle. And that is something that I think most people don’t really appreciate: how quickly and how dramatically that happens,” he says.
Bonds on the other hand showed a positive reaction to the end of the rate hiking cycle and produced some of their best performance during this period.
“What the historical analysis shows is that in the three years after the last rate hike, investment grade credit, for example, will cumulatively return more than 32 per cent,” he says.
“Those are really quite strong returns for when you think of a defensive, high quality and low volatility asset. It’s almost equity-like returns. You don’t see that often in investment grade space,” Karunakaran says.
This article is sponsored by Capital Group. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.