Capital Group remains bullish on high yield and investment grade bonds despite the bouts of volatility in fixed income markets.

This is according to Damien McCann, fixed income portfolio manager at Capital Group, who told FSA in an interview that the firm has been buying the dip during recent sell-offs.

In McCann’s view, as long as economic growth remains solid and issuers continue to be prudent in structuring their balance sheets, “it’s difficult to see how spreads should widen”.

He has this stance, despite the “wildcard” conflict in Iran and the disruption it could bring to energy prices, because artificial intelligence (AI) spending is likely to support global growth.

“You could see oil markets tightening further, and the price of oil continuing to rise, creating some economic growth headwinds,” he said. “But with so much investment in AI right now, that’s a pillar of economic growth that’s not going to change with higher oil prices.”

“The hyperscalers collectively are investing about 2% of US GDP in the form of capital expenditure this year; it’s roughly $700bn it’s probably going to be $900bn next year – almost 3% of GDP.”

“That’s just a very strong support for economic growth for the entire economy. Absent another dramatic rise in the price of oil that’s sustained, it’s difficult to see the US economy contracting.”

Tight credit spreads are not a concern

McCann is more constructive on both investment grade and high yield bonds than most investors amid seemingly tight spreads.

He said: “The narrative that you typically hear is that spreads are at or very close to all-time tights, so why would you own credit here?”

“In high yield, there’s a much more nuanced story to it. There’s been significant change in the composition of the high yield market over time in two dimensions: average credit quality and duration.”

When it comes to credit quality of high yield, he said the number of triple C rated or below credits has fallen by almost two-thirds compared with late 2010 and the percentage of double B credits has never been as high – a characteristic that McCann argues is worth about 20 basis points.

When it comes to duration, the high yield market is at roughly 2.9 years compared with historical levels of 4.5 years as CFOs have shortened duration in response to higher yields, which is something that McCann also values at around 20 basis points.

“You can’t just compare today’s high yield index spread to history; it’s apples and oranges, accounting for those two factors,” he said.

Within the investment-grade universe, McCann said there are opportunities in the technology sector to fund data centre builds.

“These are companies with credit ratings between A and AAA… but because they’re issuing in significant size, the bond market is demanding some incremental spread.”

McCann thinks some of these credit spreads will revert to their historical levels given the credit quality of the technology giants.

“Let’s say a hyperscaler brings a new jumbo 10-year issue at 70 basis points (over 10-year US treasuries) for 5.3% yield. Then if you hold it for a couple of years, it’ll tighten 30 basis points, which would be another two and a half points of return.”

“A starting yield of low fives, plus another two and a half percentage points of return to invest in the bonds of a double A rated technology titan seems pretty attractive.”

However, he is wary about certain parts of the data centre financing issuance, for example, bonds tied to a specific data centre or those with different flexibility for tenants to back out of leases.

“We look at each of these structures individually and figure out which ones we’re being paid appropriately for the risk,” he said. “There are some of these data centre financings taking place in the high yield market, where you typically have to bear construction risk if you’re investing in these bonds.”

Taking advantage of recent volatility

McCann, who runs the Capital Group Multi-Sector Income fund alongside five other named portfolio managers, revealed that trading activity has been elevated in recent years amid the ongoing volatility.

“There’s been a lot of volatility in the year-to-date period that we’ve been able to take advantage of,” he said.

“We came into the year underweight high yield, and spreads started to widen on concerns about AI’s impact on macro and employment, as well as concerns about AI undermining the strong fundamentals in the software business.”

“That was creating some weakness broadly in high yield, and so we were gradually adding as spreads were widening on the view that some of these concerns were probably overblown.”

Then, the portfolio managers started adding further to high yield bonds when the outbreak of the Iran conflict caused a dramatic widening of spreads across all sectors.

“In the middle of March, we thought that spreads had widened enough to justify an even higher weighting, and so we took our exposure to neutral on the view that we might be close to starting to de-escalate,” McCann said.

However, within a week as spreads started to tighten again, McCann said he reduced high yield exposure in a flurry of trading activity that has been a regular occurrence since Trump’s global tariff shock in April last year.

“We’ve been in this ‘buy-the-dip market’ for multiple years now, where periods of weakness are short-lived,” McCann said.

“Similarly, we added to high yield around the tariff volatility which was short-lived as the administration changed its approach to tariffs and markets rallied. We added as spreads widened and reduced as they rallied.”

No return to 2022 bond sell-off

As longer duration government bonds sell off amid ongoing concerns about the inflationary impact of the prolonged Iran conflict, some investors fear a potential repeat of the inflation spike and interest rate hike shock of 2022.

“The market’s worried about a re-run of that period, but I think a lot of our rates orientated investors and I have quite a bit of conviction that that’s not going to be the case,” McCann said.

“The setup is quite a bit different. If you go back to that period 2022, the job market was red hot,” he said.

“There are a number of indicators that say that the job market is in fine shape today, but it’s not hot like it was. Also during that period you had the benefits to consumer spending from stimulus checks related to the pandemic. A lot of that’s been spent down today, and there’re no new stimulus checks coming.”

“You also had supply chain disruption related to the pandemic, and all of the economic disruption that came with the pandemic. I’d say supply chains, with the exception of commodities coming out of the Middle East, have normalized.”

“So it was this kind of perfect storm of ingredients for an inflationary spiral that were in place then that are much less in place today.”