Bond yields are currently at their highest levels since 2007, and to put the recent selloff into perspective, U.S. Treasury yields have been the worst since 1787, when a young American republic ratified its constitution. Declines in short-term bonds could push 10-year Treasury yields above 5%. However, we believe that holding bonds for the medium to long term will yield good returns for investors, both in absolute terms and relative to other asset classes, notably cash and equities.
Following the recent bond market rout, it is important for investors with long-term perspectives to exercise patience and remain committed to a long-term approach to interest rates.
Understandably, this could prove difficult as investors have seen yields on 10- and 30-year U.S. Treasuries reach their highest levels since before the global financial crisis. The selloff could potentially diminish the billions of dollars of investments in sovereign and corporate bonds that banks, insurers, pension funds and asset managers have accumulated.
However, investing is a long-term game. Bonds remain a good bet in the medium and long term, given the emerging economic context. Although inflation may be higher than in the previous decade, yields – both real and nominal – on higher quality bonds are now at 15-year highs and are cheap not only in an absolute sense , but also compared to other asset classes, in particular stocks. Additionally, with growth and inflation slowing and the Federal Reserve (Fed) nearing or nearing the end of the interest rate hike cycle, this is historically the time when investment in bonds turns out to be the most profitable.
After the Fed’s September meeting, the narrative appears to have shifted away from lower inflation and potential interest rate cuts toward higher rates for a longer, significantly higher supply and an increase in the term premium and the risk associated with bonds. In response, yields on 10- and 30-year U.S. Treasury bonds rose to 4.75% and 4.88%, respectively, in early October, their highest levels since 2007. Considering market expectations for interest rates, they are not expected to fall below 4.% over the next decade. Given all the political, economic and structural turmoil likely over the next decade, this seems a very bold assumption.
Investors should keep in mind some data points that support this outlook:
- Valuations look positive: nominal yields have been in the 100th percentile (most attractive) over the past decade and in the top quartile over the past 20 years (Figure 1).
Figure 1: Returns ranked over time
Source: Bloomberg and ICE BofA as of September 30, 2023. Indices used: Bloomberg US Aggregate Index, Bloomberg US Treasury Index, Bloomberg US Long Treasury Index, Bloomberg Securitized Index, Bloomberg Municipal Index, Bloomberg US Corporate Index, ICE BofA US Corporate 1 -Index 3 years, Bloomberg US Long Corporate Index and Bloomberg US High Yield Index. Past performance is no guarantee of future results.
- The starting point of a yield is important for returns: even if yields rise, returns will likely be positive over a one-year period for short and intermediate bonds (and can be significantly positive if they stabilize or decline).
- Value relative to stocks is very cheap: the equity risk premium (earnings yield minus 10-year Treasury yields) is at a 15-year extreme; Bond values haven’t been this cheap relative to stocks since 2007 (Figure 2)
Figure 2: Equity risk premium (30-day moving average)
Source: Bloomberg, as of September 30, 2023. The equity risk premium is calculated using the forward earnings yield of the S&P 500 index minus the 10-year Treasury yield. Shown for illustration purposes only and should not be considered a recommendation to buy or sell any security.
- Inflation and growth are at record highs: while many expect a soft landing today, we expect lower growth and higher volatility next year.
- Historically, bond yields peak about 12 to 18 months after the first rate hike, which occurred in March 2022. Additionally, rates tend to peak before the Fed has completed the hike cycle.
- Risk assets (stocks and companies) have a negative outlook: real returns above 2% likely accelerate a risk-averse approach.
The trends we described previously still show that bonds will remain a good bet in the medium to long term. Stress is understandable, but over many years, now is not the time to panic.