US corporate bonds have performed exceptionally well over the past year, but rising inflationary pressures are rapidly increasing the downside risks. The Capital Group High Income Opportunities Fund is therefore underweight on US corporate paper and sees more opportunities in emerging markets.
Jeremy Cunningham, investment director at the US asset manager, said this in conversation with Investment Officer’s Dutch sister publication, Fondsnieuws.nl. “Corporate bond yields have been extremely good since 2020, with the result that there is a lot of positivity priced in and relatively little risk.” Over the past two years, the Bloomberg Barclays US Aggregate Index, a gauge of US investment-grade corporate bonds, is up 15%. US high-yield bonds have, remarkably, achieved similar returns over that period. “But the differences between companies and sectors within high yield are much greater,” said Cunningham.
Turning point
But the fun could soon be over for US bond investors. The reason? The American inflation spectre. “Our base case is still that US inflation is at 2.5% or slightly higher in the coming year, but certainly after the surprisingly high inflation rate [of 4.5%] a couple of weeks ago, the probability of a stronger rise in inflation has increased,” said Cunningham. “On the other hand, we are only talking about one inflation figure and that does not make a trend.”
Nevertheless, there does seem to be ‘a tipping point’ in the US, Cunningham pointed out. “If the current problems in the supply chains persist, the labour market continues to tighten and the Covid restrictions eventually disappear altogether, inflation expectations will rise further,” he explained. “The bond markets will then have to price this in.”
“Avoid beta sectors”
Capital Group is not the only fund house to warn of the impact of higher inflation on US bond markets. Luke Hickmore, investment strategist in fixed income at Aberdeen Standard Investments, notes in a market view this week that the yield spread between government bonds and credit is currently at its lowest level since 2009. This fact alone makes corporate bonds vulnerable.
Hickmore also pointed to a recent University of Michigan poll predicting inflation at 4.6% a year from now. “This poll has proven reliable in the past,” he said. “If inflation continues to rise, salaries should increase accordingly.” According to him, this could lead to a reaction on the bond market and an increase in risk premiums.
“It therefore seems logical to take a defensive position in the US corporate bond market by reducing exposure to the highest beta sectors and investing more in, for example, utilities and real estate,” concluded Hickmore.
Emerging markets
But for the Capital Group High Income Opportunities Fund, that is not really an option, said Cunningham. Income has to come from somewhere. The opportunities for this are currently best in emerging markets, he argued. EMD has lagged behind so far, mainly because of the faltering vaccination campaigns there. But eventually those economies will pick up, if only because their dependence on commodity exports is, for once, beneficial.
Cunningham explained: “Covid is having a detrimental impact on Brazil, for example, but despite a difficult vaccination campaign, rising commodity prices are helping the economy to recover more quickly.” For example, the spot price for soybeans, one of Brazil’s main exports, has already risen by more than 50% since last summer.
As a result, the allocation of Capital Group’s flexible bond fund to emerging markets has risen in recent months to around half the fund’s assets. Within EMD, the fund invests mainly in (semi)government paper in both hard and local currency. One of the main considerations is Mexico, which should benefit from the strong economic recovery there due to its strong ties with the US. The fund is also invested in emerging markets that mainly rely on commodity exports such as Russia, Brazil, Indonesia and Colombia.
Riots
The fund even increased its exposure to Colombian government bonds recently, despite the outbreak of violent street protests in the country. These have now reached such proportions that, among other things, the country has declined the organisation of the Copa America, the South American football championships that will start in less than two weeks. “The political situation in Colombia has indeed proved to be a lot more volatile and uncertain than we had anticipated,” Cunningham said.
Nevertheless, the American asset manager has increased its stake. Interest rates on Colombian government bonds have shot up as a result of the protests. The interest rate on a ten-year bond is now more than 7%, more than 2 percentage points higher than at the beginning of the year. “Colombian government paper is now very attractive from a fundamental perspective, especially compared to other Latin American countries,” noted Cunningham. Although a planned, and later cancelled, tax increase was the trigger for the protests, according to Cunningham they are also “more political than economic in nature”.
Russia
That consideration of commodity exporters is, according to Cunningham, partly coincidental. “For example, we have had a stable allocation to Russia for a long time, and we do not invest in it just because it is a commodity exporter. We are very keen, for example, on the central bank’s policy of keeping inflation under control.”
The threat of more Western sanctions against Russia following the poisoning of opposition leader Alexei Navalny by Russian security forces, followed by his arrest, does not worry Cunningham. “Despite the threat of sanctions, we see Russian bonds as a good investment at the moment,” he says.