The Federal Reserve’s aggressive interest-rate increases brought bond investors a silver lining: significantly higher yields. With the central bank now focused on cutting rates and bond market yields already off their peak, have investors missed the boat?
“The short answer is: definitely not,” says Mike Cudzil, a fixed-income portfolio manager at Pimco. “Yields are still attractive.”
What’s key for investors to remember is that “lower” is all relative. Bond market strategists and fund managers generally agree that yields are still attractive, especially relative to inflation, and will likely stay 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 (if occasionally bumpy) path. Additionally, the bond allocation in investors’ portfolios could offer price appreciation as rates fall in the months ahead.
How Are Bonds Performing?
Bonds snapped a two-year losing streak in 2023, but the road back to the green has been treacherous. Yields on the 10-year Treasury peaked at just under 5% in October, then dropped to as low as 3.79% at the end of December.
That catalyst was good news on inflation that investors took to suggest the Fed was finished with its historic tightening cycle and would soon turn to cut rates. (Bond yields and prices move in the opposite direction.) The narrative shifted again at the end of the year, amid continued data showing a strong economy and inflation news turning unexpectedly sour.
That led traders to push back their expectations for when the Fed’s first rate cut will come and to pare back their forecasts of how many times the central bank will ultimately cut rates this year. As a result, yields on the 10-year note have climbed, reaching a high of 4.33% this past week.
This back and forth in the bond market has left the Morningstar Core Bond Index down roughly 1.2% in 2024, though it’s still up 7.7% from its October 2023 low.
Yields Are Still Relatively High
Even as the bond market sold off in recent weeks, the Fed is sticking to its narrative of rate cuts in 2024. At this past week’s meeting, the median forecast from Fed officials was for three rate cuts this year, with many in the markets expecting the first to come in June.
With peak yields likely in the rearview mirror, investors may wonder if they have missed their chance to add more income to their portfolios.
“Maybe it’s not the opportunity it was last October,” says John Bellows, a portfolio manager at the fixed-income-focused Western Asset, “but it’s still a fairly high yield.” He says that’s because the Fed is still a few months away from cutting rates, and the extent of those cuts is still murky. He expects yields to move lower as that path becomes more clear.
Cudzil points to so-called real yields, which are adjusted for inflation. With the 10-year US Treasury note yielding around 4.25%, the real yield comes in just under 2%. If inflation falls even further during 2024, as most analysts expect, that already attractive return will only improve. “With an inflation rate coming down, by the Fed’s projections, to 2.5% by the end of the year, that’s a pretty attractive real rate of return,” Cudzil says.
Where to Invest In Bonds Now
Cudzil says investors improve the yields they earn from Treasuries by looking to other investment-grade bonds. He generally likes securitized products like government agency-backed mortgages over investment-grade corporate credit because they offer a better relative value on yield, liquidity, and quality.
That’s not to say that investment-grade corporate credit is without its merits. Recently, strategists from Bank of America described today’s high yields and confidence surrounding eventual rate cuts as a goldilocks environment for high-quality corporate bonds. “The thesis for buying bonds ahead of a cutting cycle remains intact,” they wrote. Within the category, Cudzil favors the Big Six financial companies (major banks including JPMorgan Chase JPM and Bank of America BAC) and some utility companies.
Overall, Cudzil sees what bond traders call the “belly” of the yield curve (bonds maturing between five and 10 years) as “the best place to put money to work.” That time frame includes the likely bottom of the Fed’s next rate cut cycle. Meanwhile, Bellows says the shorter maturities have become more attractive as the market has reduced its expectations for rate cuts.
Bonds Could See Price Appreciation If the Economy Stumbles
On Wednesday, Fed Chair Jerome Powell acknowledged that some scenarios (such as a “significant weakening” in the labor market) would prompt the central bank to reduce rates more quickly than it currently expects. That might send stocks lower, but it would also be a boon for bond prices—which, along with yields, determine how much an investor earns.
“Not only will you get your yield,” Cudzil says, “but you’ll get a more positive return because rates will come down.” This is a major difference from just six months ago, he says. Yields were a little higher, but the market was less certain about how the Fed would react to a stumbling economy, since inflation still looked sticky. “The Fed just told us that most likely, they will react if the economy underperforms. You could argue it makes fixed income even more attractive,” Cudzil explains.
Ahead of Rate Cuts, Bonds Are Even More Important for Portfolios
Bellows says the performance of the markets in the first three months of the year—stocks rising as bond yields rise and bond prices fall—is a sign that we’re returning to the classic negative correlation between stocks and bonds. That inverse relationship is why bonds are so powerful as diversifiers, but it was seriously upended in 2022 when stocks and bonds plummeted simultaneously.
“What we’re seeing so far this year is the normal relationship where yields move higher in an environment that’s good for risk assets,” Bellows adds. “It’s our expectation that it would work in the reverse if some shock were to happen.”
In other words, investors may again look to bonds to help insulate 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 valuable peace of mind.
Be Wary of Holding Cash for Too Long
Cudzil also has a warning for investors who may be reluctant to give up any historically high returns on their cash in money market funds: While those returns are “certainly” good right now, “we think you’re getting closer to the point where … reinvestment risk materializes.” This is the possibility that an investor may be unable to invest the proceeds from their current investments at the same rate of return they’re currently earning. In this case, it means 5% or greater yields on cash holdings won’t be around forever. Once the Fed starts lowering rates, those yields will drop.
“Your rate will most likely be lower, and most likely to going down over the next few months, and then be going down over the next few months,” Cudzil says. Not to mention the risk that stocks fall at the same time, which would prompt the Fed to lower rates even faster, in which case an investor who held cash for too long would also miss out on the diversification benefits associated with bonds. “I would argue for moving [into bonds] a little bit sooner,” he says.
