The Federal Reserve’s aggressive interest rate increases have brought a silver lining for bond investors: significantly higher yields. With the central bank now focused on cutting rates and bond market yields already far from their peaks, have investors missed the boat?
“The short answer is: definitely not,” says Mike Cudzil, fixed income portfolio manager at Pimco. “Returns remain attractive.”
The key thing for investors to keep in mind is that “lower” is all relative. Bond market strategists and fund managers generally agree that yields remain attractive, particularly relative to inflation, and will likely remain higher than before the pandemic.
As a result, there are plenty of opportunities in the fixed income sector, as long as inflation continues on its downward (albeit sometimes bumpy) trajectory. Additionally, bond allocation in investors’ portfolios could provide price appreciation as rates fall in the coming months.
How are bonds performing?
Bonds ended a two-year losing streak in 2023, but the return to green has been fraught with challenges. Yields on the 10-year Treasury note peaked at just under 5% in October, then fell to 3.79% in late December.
This catalyst was good news on inflation that investors interpreted as suggesting the Fed had completed its historic tightening cycle and would soon turn to cutting rates. (Bond yields and prices move in the opposite direction.) The narrative shifted again as the year ended, amid persistent data showing a strong economy and news on inflation that worsened by unexpected way.
That has led traders to push back their expectations for when the Fed will first cut rates and revise downward their forecasts for how many times the central bank will ultimately cut rates this year. As a result, 10-year bond yields have climbed, reaching a high of 4.33% last week.
These back-and-forths in the bond market have left the Morningstar Core Bond Index down about 1.2% in 2024, although it is still up 7.7% from its lowest d October 2023.
Yields are still relatively high
Even though the bond market has sold off in recent weeks, the Fed is sticking to its talk of rate cuts in 2024. At last week’s meeting, Fed officials’ median forecast was for three cuts rate this year, and many market participants expected the first to come in June.
With peak returns likely in the rearview mirror, investors may wonder if they missed their chance to add more income to their portfolios.
“Maybe it’s not the opportunity that presented itself last October,” says John Bellows, a portfolio manager at Western Asset, a firm focused on fixed income, “but the yield is still quite pupil”. He says that’s because the Fed is still months away from cutting rates and the extent of those cuts is still unclear. He expects yields to fall as that trajectory becomes clearer.
Cudzil points to so-called real returns, which are adjusted for inflation. While the yield on the 10-year U.S. Treasury note is around 4.25%, the actual yield is just under 2%. If inflation continues to fall in 2024, as most analysts predict, this already attractive yield will only improve. “With the Fed’s projected inflation rate falling to 2.5% by the end of the year, that represents a pretty attractive real rate of return,” Cudzil says.
Where to Invest in Bonds Now
Cudzil says investors are improving the returns they get from Treasuries by switching to other investment-grade bonds. He generally prefers securitized products like mortgages backed by government agencies over investment-grade corporate loans because they offer better relative value in terms of yield, liquidity and quality.
This is not to say that investment grade corporate credit is without merit. Recently, Bank of America strategists described the current high yields and confidence surrounding possible rate cuts as an ideal environment for high-quality corporate bonds. “The case for buying bonds before a tapering cycle remains intact,” they write. In this category, Cudzil favors the big six financial companies (the big banks including JPMorgan Chase JPM and Bank of America BAC) and some utility companies.
Overall, Cudzil views what bond traders call the “belly” of the yield curve (bonds maturing between five and 10 years) as “the best place to make money grow.” This period includes the likely low point of the Fed’s next rate cut cycle. At the same time, Bellows says shorter maturities have become more attractive as the market has reduced its expectations for rate cuts.
Bonds could see price appreciation if economy stumbles
On Wednesday, Fed Chairman Jerome Powell acknowledged that certain scenarios (such as a “significant weakening” in the labor market) would prompt the central bank to cut rates more quickly than it currently plans. That could send stocks lower, but it would also be a boon for bond prices, which, along with yields, determine an investor’s income.
“Not only will you get your yield,” Cudzil says, “but you’ll get a more positive yield because rates will go down.” This is a major difference from just six months ago, he says. Yields were a bit higher, but the market was less sure how the Fed would respond to a struggling economy, with inflation still appearing stubborn. “The Fed just told us it would most likely respond if the economy underperforms. You could say this makes fixed income even more attractive,” says Cudzil.
Before rate cuts, bonds are even more important for portfolios
According to Bellows, the performance of markets in the first three months of the year (stocks rise as bond yields rise and bond prices fall) is a sign that we are returning to the classic negative correlation between stocks and the obligations. This inverse relationship explains why bonds are so powerful as diversifiers, but it was seriously upended in 2022 when stocks and bonds fell simultaneously.
“What we’re seeing so far this year is a normal relationship where yields are rising in a favorable environment for risk assets,” adds Bellows. “We hope it would work the other way around if a shock were to occur.”
In other words, investors may once again turn to bonds to protect their portfolios against unexpected drops in the stock market. Yields may be slightly lower than last fall, but investors can make up some of that difference with peace of mind.
Be wary of holding cash for too long
Cudzil also issues a warning to investors who might be reluctant to give up historically high returns on their cash in money market funds: While those returns are “certainly” good right now, “we think you’re getting close from the point where . …the reinvestment risk materializes. This is the possibility that an investor will not be able to invest the proceeds of their current investments at the same rate of return that they are currently earning. In this case, that means returns of 5% or more on cash won’t be around forever. Once the Fed starts cutting rates, these yields will fall.
“Your rate will most likely be lower, and most likely go down over the next few months, and then go down over the next few months,” Cudzil says. Not to mention the risk that stocks could fall at the same time, prompting the Fed to cut rates even faster, in which case an investor who held cash too long would also miss out on the diversification benefits associated with bonds. “I would advocate moving [into bonds] a little earlier,” he said.