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here’s no doubt that 2022 was a challenging year for fixed income. But with the US Federal Reserve expected to end its rate-hiking cycle in
mid-2023, investors are faced with two options: sit on the sidelines or invest.
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“Net zero commitments are set to revolutionise the world of long-dated real assets”
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FIXED INCOME
Professional Investors Only
Featured in this Spotlight
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Ketish Pothalingam Portfolio Manager, EVP
Ketish is a member of PIMCO’s ESG team, focusing on corporate credit and global bond ESG portfolios
Samuel Mary ESG Research Analyst, SVP
Samuel focuses on the integration of ESG factors into PIMCO's portfolio management and credit research
A flexible approach to global fixed income
High yield is finally deserving of its name again
An attractive income without lowering quality
A year of opportunity for fixed income
In this Spotlight guide, we hear from Mike Gitlin, Head of Fixed Income at Capital Group, on the prospects for this year and how fixed income investors might cautiously start to take on more risk.
“Investors are faced with two options: sit on the sidelines or invest”
Risk factors you should consider before investing:
There are reasons for optimism in 2023
Navigating the foggy road to normal
All information and opinions as at 31 December 2022 unless otherwise stated. Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. The information provided is not intended to be comprehensive or to provide advice. This information has been provided solely for informational purposes and is not an offer, or solicitation of an offer, or a recommendation to buy or sell any security or instrument listed herein. FOR PROFESSIONAL INVESTORS ONLY Financial promotion This material, issued by Capital International Management Company Sàrl (“CIMC”), 37A avenue J.F. Kennedy, L-1855 Luxembourg, is distributed for information purposes only. CIMC is regulated by the Commission de Surveillance du Secteur Financier (“CSSF” – Financial Regulator of Luxembourg) and manages the fund(s), which is a (are) sub-fund(s) of Capital International Fund (CIF), organised as an investment company with variable capital (SICAV) under the laws of the Grand Duchy of Luxembourg and authorised by the CSSF as a UCITS. All information is as at the date indicated unless otherwise stated and subject to change. Facilities to investors (tasks according to Article 92 of the Directive 2019/1160, points b) to f)) are available at www.eifs.lu/CapitalGroup The list of countries where the Fund is registered for distribution can be obtained at all times from CIMC or online at www.capitalgroup.com/europe Compensation will not be available under the UK Financial Services Compensation Scheme.
Spotlight on: fixed income at Capital Group
Financial promotion
For Professional Investors Only
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We then look at three different approaches that fixed income investors might take depending on their objectives and risk appetite. First, Investment Director Flavio Carpenzano discusses the outlook for high-quality credit and the sectors to potentially be wary of in 2023. Next, portfolio managers Shannon Ward and Kirstie Spence assess the high-yield universe; and, finally, Investment Director Ed Harrold outlines the benefits of a more flexible approach to fixed income.
This material is not intended to provide investment advice or be considered a personal recommendation. The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment. Past results are not a guarantee of future results. If the currency in which you invest strengthens against the currency in which the underlying investments are made, the value of your investment will decrease. Currency hedging seeks to limit this, but there is no guarantee that hedging will be totally successful. The Prospectus – together with any locally-required offering documentation – sets out risks, which, depending on the fund, may include risks associated with investing in fixed income, derivatives, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems. The funds may invest in financial derivative instruments for investment purposes, hedging and/or efficient portfolio management.
• • • • • •
Other important information The information in relation to the index is provided for context and illustration only. The fund is an actively managed UCITS. It is not managed in reference to a benchmark Investors acquire shares of the fund, not the underlying assets. The fund(s) is (are) offered only by Prospectus, together with the UCITS Key Information Document (KID). These documents, together with the latest Annual and Semi-Annual Reports and any documents relevant to local legislation, contain more complete information about the fund(s), including relevant risks, charges and expenses, and should be read carefully before investing. However, these documents and other information relating to the fund(s) will not be distributed to persons in any country where such distribution would be contrary to law or regulation. They can be accessed online at www.capitalgroup.com/europe, where latest daily prices are also available. The tax treatment depends on individual circumstances and may be subject to change in future. Investors should seek their own tax advice. This information is neither an offer nor a solicitation to buy or sell any securities or to provide any investment service. A summary of Fund Shareholder Rights is available in English, French, German, Italian and Spanish at https://www.capitalgroup.com/eu/investor-rights/ CIMC may decide to terminate its arrangements for marketing any or all of the sub-funds of Capital International Fund in any EEA country where such sub-fund(s) is/are registered for sale at any time, in which case it will do so in accordance with the relevant UCITS rules. © 2023 Capital Group. All rights reserved.
’A flexible approach to global fixed income’
‘High yield is finally deserving of its name again’
An attractive income without lowering credit quality
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n 2022, we saw disinvestment and losses for bond funds. But looking forward, we can be optimistic about a year of reinvestment and opportunity, according to Mike Gitlin, Head of Fixed Income at Capital Group.
I
“With a long-term lens, one can better understand the strong normalising effect that disinflationary forces could have”
The recovery may not be rapid, but fixed income investors can start to take advantage of opportunities as 2023 progresses, says Mike Gitlin
“A look at history shows that investing when the Barclays Global Aggregate Index is yielding around 3.5% and high yield is around 10%, as they are now, has produced strong results over the following years, ” he says. “If we start to see inflation coming down, then we would expect central bank hiking to peak, and given the fact yields are as high as we have seen for several years after recent weakness, that should offer a fertile environment for fixed income.”
In these volatile times, Gitlin emphasises what Capital Group sees as the four roles of fixed income: diversification from equities, capital preservation, income and inflation protection. Not all of these worked out in 2022, as correlation of the asset classes impacted diversification, and assets with any duration at all found themselves unable to preserve capital. But over the long term, these remain Capital Group’s guiding principles, or “true north”.
“True north”
Capital Group expects interest rates to peak at about 5% in the US, but that said, Gitlin advises against trying to time markets. “We suggest that an averaging-in strategy, investing regularly rather than trying to predict the rate peak, is ultimately a better approach to take.
“At Capital Group, we are looking to follow a similar long-term approach with our own bond funds. Over the last 18 months, we have broadly been below-index in terms of interest-rate risk and credit risk in our portfolios, reflecting caution on duration and credit,” he explains.
Gitlin explains that another thing that makes Capital Group different is its funds do not diverge from their stated objective. “Our focus is on creating portfolios that aim to deliver on our clients’ expectations. Bond funds that engage in ‘scope creep’ have a real possibility of disappointing when clients need them most,” he adds.
“We remain committed to each strategy’s style and adhere to portfolio objectives throughout market cycles.”
Capital Group is particularly able to take a long-term view because, as a private company, it is not beholden to shareholders. “We have invested through periods of significant uncertainty at times when other investment managers have held back,” says Gitlin.
“Assuming we see inflation falling and rates peaking this year, we would expect to neutralise that duration position and start taking more credit risk in areas where valuations look exciting, including high yield and emerging market debt.”
Gitlin emphasises this will be a gradual process over the next six to 12 months. “While we are starting to see more attractive opportunities, we are not expecting a rapid ‘snap-back’ like in March/April 2020,” he adds.
Meanwhile, over the broader horizon, Gitlin emphasises the value of taking a longer term view, particularly on inflation. “Navigating the foggy road to normal has never been more challenging,” he says. “But with a long-term lens, one can better understand the strong normalising effect that disinflationary forces – such as rising debt levels, technological advancements and ageing demographics – could have.
“Having a clear understanding of these can help investors better find their way.”
He also highlights the importance of The Capital System , which seeks to drive the incorporation of diverse views while avoiding groupthink. Portfolios are divided into segments, each run by an individual manager, bringing in multiple perspectives while reducing key-person risk.
Managers are incentivised to take a long-term view. “Our portfolio managers and analysts are not compensated according to the level of assets they manage, but on their longer term results, notably with an emphasis on five and eight-year periods,” he says. “This makes superior long-term returns their sole goal.”
“Bond funds that engage in ‘scope creep’ have a real possibility of disappointing when clients need them most”
1
(1) Data from Capital Group and Bloomberg (as at 30 September 2022) shows the average five-year forward returns going back to 2001 are 5.6% when the Barclays Global Aggregate Index is yielding around 3.5%, and 9.7% when the Bloomberg Global Corporate High Yield Index is yielding around 10%.
Sources.
TM
‘There’s no need to dive into lower credit quality to find attractive income’
he global sustainable bond market has materially grown and evolved over the past few years. PIMCO recognises the impact that climate change will have on the global economy and offers investors – through their bond allocations – the means
to manage climate-related risks and take advantage of the opportunities associated with the transition to a net zero emissions economy.
Flavio Carpenzano discusses the outlook for high-quality credit and the sectors to be wary of in 2023
“You don’t find other funds in the market that are managed in this way”
Josh Anderson, Portfolio Manager
“In the US, our concern is that we haven’t seen the impact on shadow banking, the non-traditional banking sector”
Alfred Murata, Portfolio Manager
Cautious positioning
Even within the context of a high-quality portfolio, Carpenzano says the fund is taking a relatively conservative positioning at present due to the level of uncertainty in the global economy. “It’s very difficult to define a baseline scenario for 2023, because we probably haven’t yet seen the real impact of these higher rates,” he explains.
“We’ve had a taste of what could be to come with the issues around pension funds and liability-driven investment in the UK, where you have a big repricing in gilts and the volatility this creates in the market. In the US, our concern is that we haven’t seen the impact on shadow banking, the non-traditional banking sector.
“The sell-off that we saw in fixed income in 2022 has been the worst in decades,” says Flavio Carpenzano, Investment Director for Capital Group Global Corporate Bond Fund (LUX). “The positive outcome of such a fast repricing is that yields have rapidly reached levels we have not seen in generations. That means there are opportunities to achieve a good income without necessarily diving into lower credit quality.”
high-yield or other riskier assets. As always, it is important to stress the usual risks around credit investing, and in this case, there is no guarantee that current income levels will continue into the future.
oday’s attractive yield levels have implications for all areas of the fixed income market, but particularly in the high-quality space. That’s because investors can currently get access to an attractive income without feeling pressure to dip into
In this context, Carpenzano believes the Global Corporate Bond Fund can fulfil several of the different objectives that investors tend to have when buying into fixed income. “High-quality credit offers a form of capital preservation because, historically, the default rate in these asset classes has been low to zero. It provides a degree of diversification from equities as well, partly due to its higher duration, which benefits when rates decrease. And given the current market’s higher rates and inflation, investment grade credit is providing an attractive income.”
“This includes the private credit market, which is untested and usually takes the form of floating-rate notes, which are going to be impacted by these higher rates.”
For different reasons, the fund is also cautious about midstream energy, and has a below-index position in this sector as a result. These companies have enjoyed huge increases in earnings and profits due to high commodity prices, but they haven’t taken the opportunity to deleverage their balance sheets, says Carpenzano.
“They enter into this recession cycle highly leveraged, and because their capital expenditure for 2023 is very high, they won’t have the ability to deleverage organically,” he says. “This situation is compounded by a challenging technical environment, given a potential increase in supply and valuations.”
By contrast, the banking sector is a high-conviction area for the portfolio. “It has undergone 20 years of deleveraging, so even if you have a recession and an increase in non-performing loans, the banks can absorb these losses,” he continues. “We favour more senior bonds in this space, where valuations are also quite attractive. The spread has increased due to recession risk but also due to technical factors stemming from high supply, particularly in the US.”
The Corporate Bond Fund’s ability to pursue these sorts of opportunities is enhanced by the fact Capital Group’s credit analysts are also making investment decisions.
“Not only do they provide a recommendation on single names, they also directly invest money where they see the strongest conviction,” Carpenzano explains. “They are specialists in their particular area. That’s quite unique – you don’t find other funds in the market managed in this way.
“The alpha generation is coming mainly from credit and bottom-up selection in investment-grade corporate bonds because, in general, the fund is not allowed to invest tactically in high yield, the duration is kept in line with the reference index and the currency risk is fully hedged.”
Unique use of specialists
For bond investors seeking higher income, the US high yield market is healthier than it has been in years, and there are also pockets of value to be found in emerging market debt, say Shannon Ward and Kirstie Spence
Even with a softer macroeconomic backdrop, Ward says the US high-yield market appears healthier and more stable than it has been in many years. “We have a weaker economic environment but a stronger asset class, and the combination has resulted in yield spreads that are in line with historical averages.”
US companies looking attractive
KIRSTIE SPENCE’S EM DEBT OUTLOOK
Local currency debt – preference for Latin America “We currently see the most value in Latin American countries, such as Brazil, Mexico and Colombia, that have hiked interest rates early. This has helped keep inflation under control and support exchange rates. Countries in Latin America have also been large beneficiaries of rising commodity prices and have been less exposed to the conflict in Ukraine.”
That’s according to Shannon Ward, a portfolio manager at Capital Group. She is one of four portfolio managers who run Capital Group’s Global High Income Opportunities strategy, which largely invests in the high-yield market as well as emerging market debt.
he high-single-digit yields that this sector is offering are renewing investor interest in this asset class, even as the spectre of a recession raises some concerns. High yield is finally deserving of its name again.”
Ward emphasises that Capital Group does not believe in timing markets, and that the economic environment remains uncertain. However, she nevertheless believes it makes sense for investors to build selective exposure to high yield at this moment, while also being mindful of potential risks in this part of the bond market, such as higher risk of default and potential for greater volatility.
“If the actions of the US Federal Reserve (Fed) are not successful in bringing down inflation, or if they push the economy into a longer, deeper recession, then the high-yield market – and credit and risk assets more broadly – could face a bumpy ride. But that negative scenario might be reflected in prices already,” she says.
“We have a weaker economic environment but a stronger asset class”
Higher spreads and yields
Past performance is not a guarantee or a reliable indicator of future results
Data as at 22 November 2022. OAS: option-adjusted spread. Source: Index ICE BofA US High Yield.
At the beginning of 2022, US high-yield credit spreads were close to all-time lows at around 300 basis points (bps). Yields were just 4.3%. By November, spreads had increased to around 500 bps and yields more than doubled to over 9%.
Fundamentals have also improved. Many weaker high-yield issuers defaulted during the pandemic; this, and the fact that the companies that have survived are typically much stronger, has helped increase the overall credit quality of the index. As the chart below shows, 50% of the US High Yield Index is now rated BB (the highest credit quality for high yield).
BLOOMBERG US CORPORATE HIGH YIELD INDEX WEIGHT BY CREDIT QUALITY
Data as at 30 November 2022. Sources: Capital Group, Bloomberg, Bloomberg Index Services Ltd., JPMorgan
BB
B
CCC
and below
36%
41%
22%
50%
38%
11%
2008
2022
Many high-yield companies took advantage of ultra-low interest rates, especially in 2021, to term out their debt. “Savvy corporate management teams have tapped into the low rate and favourable credit environment of the past few years to complete their financing requirements,” says Ward.
While macroeconomic headwinds could mean that default rates may rise from these very low levels, it does not seem likely that they will spike sharply higher. This assessment of potential default levels remains a key part of the risk/reward balance when considering high yield.
“Some of the more developed EM countries are now less reliant on foreign borrowing than in previous periods of volatility”
Global factors are likely to continue to weigh on emerging market debt (EMD), but there is more yield on offer both in nominal and real terms, and the high starting yields can offset subsequent price volatility.
Pockets of opportunity
The difference in real interest rates offered by emerging markets compared to developed markets has been somewhat eroded, but it remains positive and attractive relative to other asset classes, while EM exchange rates remain highly undervalued given the continued strength of the dollar.
Kirstie Spence, another of the portfolio managers working on the Global High Income Opportunities fund, emphasises the importance of using research-driven investing to identify countries that are more likely to withstand current market volatility.
Along with inflation, she highlights debt sustainability as an area where regional differences need to be monitored. While EMD looks vulnerable to external financing difficulties on the surface, most of the issues have taken place in frontier markets, she says.
“It is a completely different story for some of the more developed EM countries, many of which are now less reliant on foreign borrowing than in previous periods of volatility,” she explains. “These countries have lengthened the maturity of their issuance, and the foreign ownership of local currency bonds has broadly decreased, which should result in a lower risk of sudden reversal in capital flows.
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External debt – opportunities within higher yielding credits “We continue to find compelling opportunities within external debt, mainly within the higher yielding part of the asset class.
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“We see value in some distressed or quasi-distressed credits, where many of the difficulties have already been priced in, such as Tunisia. We also like some of the higher-yielding bonds that are deemed safer and which have widened alongside the broader sell-off, such as the Dominican Republic, Honduras, Senegal and Angola and some high-yield EM credits with access to external funding, such as Egypt.”
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EM corporates “Fundamentals within EM corporates look to be in better shape compared to developed market (DM) corporate peers, as EM corporate treasurers have taken a more prudent approach to borrowing.
“The geographic representation and risk structure of EM corporates is quite different to sovereigns, and so provides an element of diversification. Shorter-dated investment-grade bonds inside the corporate world can offer more defensive positioning.”
Shannon Ward, Portfolio Manager
Kirstie Spence, Portfolio Manager
OAS bps (lhs)
Yield to worst % (rhs)
“
“And furthermore, if the Fed manages a ‘softer landing’, high-yield bonds could rally.”
apital Group Global Total Return Bond Fund (LUX) differs from the firm’s other fixed income offerings in that it takes a total return approach that is inherently flexible, with the latitude to dynamically adapt to market
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Ed Harrold explains how Capital Group Global Total Return Bond Fund (LUX) can dynamically adapt to market conditions
One of the key benefits of the total return approach, according to Harrold, is that it can be more focused on areas of the market in which the firm’s analysts have high conviction. “That’s very different to a traditional index-based approach, where effectively you’re having to use up some of your risk budget (tracking error) in avoiding parts of the market where you see less value,” he says.
Investing with conviction
“With a total return approach, you can focus on parts of the market where you have a more positive outlook”
conditions. Again, this flexibility can also bring risk as well as opportunity, with the fund investing in what are deemed more volatile parts of the bond market, for example.
“It has very broad flexibility to invest globally across different parts of the fixed income markets, and also in terms of risk metrics,” says Investment Director Ed Harrold. “For example, it has a duration range of between zero and 10 years, broad currency exposure, and is flexible in terms of credit risk, being able to hold up to 50% in sub-investment grade.
“For example, over 2022, we’ve had lower levels of conviction in Japanese or UK markets. With a tracking error approach, you have to use up a significant portion of your risk budget to avoid those markets, as, together, they represent around 15% of the Global Aggregate Index. With a total return approach, you can just focus on parts of the market where you have a more positive outlook.”
High yield is a good example of how the fund uses its flexibility. Towards the end of 2020 about 25% of the fund was invested in high yield, during a period when the COVID recovery was under way, markets were still benefiting from low interest rates, and quantitative easing was still in full flow. The fund’s allocation is now down to around 15% , reflecting the slowing growth environment and reduced appetite for exposure to riskier assets.
“The reach for resilience will likely be accompanied by more regulation and protectionism, which could weigh on long-term growth”
“We design it that way to give our portfolio managers the full tools available to meet the total return objective , with the ability to position more positively to capture opportunities when available, or more defensively when appropriate. Over a market cycle we think that could translate to a return of around 3%-4% on an annualised basis.”
The fund’s portfolio managers use a volatility framework to help them construct the portfolio and manage the overall level of risk taken. The volatility budget is typically 4%-6% based on the historical volatility of the broader global bond market.
Equally, that brings flexibility to rebuild exposure in future, says Harrold. “We could see opportunities to add to high-yield return at some point next year, as we move through the remainder of the rate-hiking cycle and with potential for spread volatility, which could bring more attractive valuations.”
The fund as a whole is cautiously positioned currently due to the level of uncertainty in markets. “There’s an extremely high level of uncertainty in terms of the depth and length of recession in various countries and our focus at the moment is trying to unpick that a little bit more,” adds Harrold.
The team has increased the duration of the fund slightly towards the end of 2022, from five to around seven years, and Harrold is positive about where yield levels are now. “We’ve got to a point where yields today are much, much higher than they were at the end of 2021,” he says. “That offers a very compelling entry point in terms of future returns.
“At this moment in time, we are able to generate a high level of yield while maintaining a relatively cautious approach, a great combination of quality with strong return potential.”
High level of uncertainty
“At this moment in time, we are able to generate a high level of yield while maintaining a relatively cautious approach”
2
(1) The investment objective of Capital Group Global Total Return Bond Fund (LUX) is to maximise total return over the long term. The fund invests worldwide primarily in Investment Grade Bonds and High Yield Bonds of governmental, supranational and corporate issuers and in other fixed income securities.
(2) As at 30 November 2022.
A FUNDAMENTAL RESEARCH-DRIVEN GLOBAL ASSET MANAGER
Assets under management are preliminary for 30 September 2022. Capital Group manages equity assets through three investment groups. These groups make investment and proxy voting decisions independently. Fixed income investment professionals provide fixed income research and investment management across the Capital organisation; however, for securities with equity characteristics, they act solely on behalf of one of three equity investment groups. Assets under management totals may not reconcile due to rounding. Fixed-income assets managed by Capital Fixed Income Investors. All values in USD.
Our global fixed income capabilities
Assets under management are preliminary for 30 September 2022. (1) Includes both equity and fixed income research offices around the world with fixed income research presence in Singapore, Geneva, London, New York and Los Angeles. Our fixed income trading centres are inSingapore, London, New York and Los Angeles. (2) Mainly comprises money markets and US municipals.
Distinctive portfolio construction approach
Aligned with investor success
A long-term perspective aligns our goals with the interests of our clients
Employee owned
organisation, investing since 1931
Long-term approach
driven by global fundamental research
Multiple portfolio manager teams
combine high conviction with collaboration
Global reach,
with more than 450 Capital Group investment professionals worldwide
Aligned with investors,
with managers personally invested in their eligible mandates
research offices around the world
45+ years
experience in fixed income investing
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Achieving superior, long-term returns is our only goal, so managers are rewarded for their results, not the level of assets they manage
With one of the highest retention rates in the industry , we have some of the most experienced investment professionals
As a privately owned, independent organisation, we can base our decisions on a long term perspective
Collectively, Capital Group associates are significant investors in the company's investment offerings
Compensation basis Emphasis increasing with each successive period
Equity and fixed income portfolio managers' experience
Equity
Fixed income
28
23
25
16
Years with Capital Group
Years of investment experience
Years
3
5
8
As at 30 June 2022 unless otherwise stated. (1) As at 31 December 2021. Source: Morningstar, based on data from Capital Group's American Funds, which are not available for sale outside the United States. This statement refers to the overall portfolio manager retention rate across Capital Group. It is based on the percentage of managers who have stayed with the firm during the past five calendar years.
Valuing strength in teams with diverse styles and perspectives
Principal Investment Officer (PIO) Has ultimate responsibility for portfolio
Multiple portfolio manager teams Team approach, no ‘star’ system
Avoids risks associated with isolated decision-making Designed to lower volatility through diversification Provides stable long-term approach through succession planning
• • •
Analysts as investors
Sector specialists conduct fundamental research to uncover the most compelling opportunities Inform portfolio managers by investing in their highest convictions in the research portfolio
• •
Individual perspectives building diversified portfolios
Portfolio managers bring together high-conviction ideas from the research portfolio across the full opportunity set Portfolio managers construct the portfolio that best reflects their individual analysis and style preference
A focus on consistent outcomes We strive for strong risk-adjusted results, without style drift
Research is the cornerstone Equity and fixed income analysts work together to develop differentiated insights
A culture of collaboration Portfolio managers and analysts collaborate as peers, creating portfolios that reflect multiple perspectives
Multi-layered risk management Helps ensure portfolio exposures are intentional and properly scaled
Analysts manage money Analysts are empowered to invest in their best ideas, alerting portfolio managers to their strongest convictions
