Susan Dziubinski: Before we look ahead, let’s look back at 2023. How has the entire bond market performed?
Dave Sekera: After the worst year in bond history last year, fixed income has rebounded a bit and is in positive territory this year. For example, if I look at the Morningstar Core Bond Index, which is really our indicator of the overall market, through December 5, it was up 2.77%. I would like to point out that the performance is still depressed this year. We saw some price depreciation as interest rates increased, which offset some of the return investors would have otherwise received.
Dziubinski: Which parts of the bond market have the best performance in 2023?
Sékera: Bonds that trade at a credit spread to Treasuries have had the best performance so far this year. For those of you who are unfamiliar with what the credit spread is, it is additional compensation you receive as an investor on maturities with comparable U.S. Treasury bonds. This offsets the additional risk associated with different types of bonds that pose a risk of credit downgrade or default. For example, in the market for asset-backed securities, also known as ABS, these increased by just over 5%. But the biggest winners this year have been corporate bonds. The Morningstar Corporate Bond Index, our gauge of investment-grade corporate bonds, is up nearly 5.5%. In the junk bond market, the Morningstar High Yield Index rose more than 10%.
Dziubinski: What does the yield curve look like as 2023 draws to a close?
Sékera: Well, if you look at the yield curve, it’s more inverted today than it was at the end of last year. This is really just because the Fed raised the federal funds rate quite substantially during the first half of 2023. If I look at the shorter end of the curve, one-month Treasuries have risen of 140 basis points. It really had to do with the Fed. I think they were up about 100 basis points at that point. Then, on the longer end of the curve, the 10-year yield rose, but it only increased by 30 basis points, to 4.18% as of December 5.
Dziubinski: We enter 2024 with higher interest rates than 2023, but we have seen 10-year Treasury yields fall in recent weeks after peaking at around 5%. What is Morningstar’s forecast for short- and long-term rates in 2024?
Sékera: For 2024, we expect short- and long-term rates to fall. Our current near-term forecast is that the Fed will begin cutting the federal funds rate. We expect this figure to fall into a range of 3.75% to 4.00% by the end of the year. In fact, we expect this figure to continue to decline in 2025, reaching 2.25%. At the longer end of the curve, we forecast the 10-year rate to average 3.60% during 2024, also remaining on a downward trend through 2025 and averaging around 2.75% in 2025.
Dziubinski: So, given your expectations, Dave, which parts of the bond market do you expect to perform the best in 2024?
Sékera: Based on these interest rate forecasts, I think long-term bonds should perform the best in 2024. Right now, that seems like a better short-term return because you’re getting a yield higher, but you get very little. price appreciation over time with short-term bonds. Additionally, when you purchase these short-term bonds, you are subject to the interest rates in effect at their maturity, when you then need to reinvest that proceeds. Since you expect rates to fall in the short term, you get that higher yield for a little while. Whether it’s six months, a year, or two years, but as those short-term rates go down, you’re going to get a lower total return when those rates go down over the same period of time.
Today, long-term rates are slightly lower, but you benefit from the added duration effect of these long-term rates. This means that the prices of long-term bonds will increase the further away from the yield curve as those yields fall. While you are getting these lower returns, you are guaranteeing returns that will be higher now compared to what they will be in the future. What happens is that investors are willing to pay higher prices for these bonds with higher coupons. If yields move as we expect, we expect you’ll get higher total returns for these bonds over the long term, based on the combination of not only the yield you get, but also the price appreciation.
Dziubinski: Wrap the bonds for us, Dave. How should bond investors view their bond investments today?
Sékera: Well, in our mid-year bond outlook, I think it was maybe July when we released that, we advocated that investors start looking at longer-term bonds. We still share this view today. Based on our economic outlook and interest rate forecasts, we believe these long-term bonds are the most attractive part of the curve. Just to put things in context (again, this is not a forecast and simply a back-of-the-envelope estimate), but if rates actually translate as our economic team predicts , we think you could see total returns and long-term bonds over the next year appreciate as much as 8% to 9%. Half of that will be the amount you earn on yield, and the other half will come from price appreciation. Then, changing the subject a little bit, taking a look at the corporate bond market, I’m actually not as excited about corporate bonds right now as I was about our outlook for 2023.
Corporate credit spreads have tightened to levels that, while still adequate given our economic outlook and interest rate forecasts, are by no means cheap. My concern is that slowing economic growth in the coming quarters could generate negative sentiment in the markets. We may see some investors start to price in potentially higher default rates or downgrade rates. In the first half of 2024, credit spreads could start to widen a bit. But I think once we get to the middle of the year, once the market starts to price in the economic recovery that we expect later in the year, I would expect the spreads to come back at their current level. That’s why, overall, I think a market weighting or neutral position on companies is probably the right way to go.
This is an excerpt from this week’s episode of Monday morning with Morningstar’s Dave Sekera. Watch the full episode, 5 Cheap Stocks to Buy Before Interest Rates Drop Further. See a list of previous episodes here.