Are higher yields signaling that it’s time for investors to review their bond allocations? And how patient is the Federal Reserve with current rates? Answers are coming up.
From Thrivent Asset Management, welcome to Advisor’s Market360™. A podcast for you, the driven financial advisor.
Just a few years ago, the investment world was bemoaning the flood of cheap money, the prevalence of negative interest rates, the end of inflation, and… even the value of government bonds in a diversified portfolio?
And then the unthinkable happened. Inflation surged higher and faster than it had in forty years – hitting levels not seen since the late ‘80s. The Federal Reserve, or Fed, had no choice but to respond just as aggressively by quickly raising interest rates.
And while the Fed’s aggressive moves have caused pain in many sectors of the economy, they do have a silver lining – greatly increased bond yields. In a minute, we’ll take a deeper dive on the Fed’s strategy going forward, but first we wanted to address the investment implications of this turn of events. And for that, we turned to Steve Lowe, Thrivent Asset Management’s Chief Investment Strategist, for his thoughts.
For almost a decade, bond yields were in the doldrums, but the recent confluence of events have once again put wind in the sails of these fixed-income vehicles. Are yields now high enough to be attractive on an absolute basis? Absolutely. The yields that could be locked in for the life of a bond across the major fixed-income asset classes are not only compelling relative to their recent history, but also relative to current inflation, and to the current economic environment. As such, we believe it’s time for investors to reconsider their bond allocations. To help with that, we have five suggestions:
Suggestion one: reconsider your cash allocation. Many investors have built up relatively large cash positions over the past few years, because understandably they worried about both the health of the equity markets and rising bond yields. And while the yield provided on most money market funds today is still attractive, the problem is that if short-term interest rates start to fall, those attractive levels won’t last very long.
Holders of cash are likely to have a steadily increasing “reinvestment” risk – the risk that what you are earning today won’t be available when the holdings mature, resulting in the need to reinvest the money. While holders of, for instance, a three-year bond won’t have that problem for three years, holders of money market funds or various “cash plus” exchange traded funds, or ETFs, will start to see the problem as soon as rates start to fall.
So, what could you do with the cash? That brings us to suggestion two: consider short-duration securities, like the three-year bond mentioned previously, issued by either the U.S. Treasury or high-quality companies. These allow investors to lock in higher yields for longer. Additionally, they could experience some capital appreciation.
Suggestion three is to look at long-duration Treasuries. We think that yields from Treasury bonds with maturities of 10 years and longer have likely peaked or soon will. While we could be wrong, if we are right, the total return realized in longer-dated bonds could be impressive as the capital appreciation gained from falling rates is added to the yield earned just by holding them.
Alternatively, if rates don’t fall quickly, or if we are simply wrong and they drift higher in the coming year, their relatively high yield provides both income and some mitigation against those rising rates.
Our fourth suggestion is to consider owning more investment-grade corporate bonds. These bonds offer attractive yields considering both the underlying Treasury yields, and the spread offered over that yield has risen from the lows of 2020. While this is most apparent in the high-yield market – bonds of a lower quality than investment grade – we are not convinced that they adequately compensate for the risks if the economy stumbles. However, we are more positive on the ability of investment-grade corporate bonds to weather economic storms.
Like U.S. Treasuries, the current yields on corporate bond markets may offer significant protection against further rises in rates or spreads and a potentially more attractive upside should yields fall.
Our fifth suggestion is to consider active management over passive. Investors always have a choice to invest in a fund that tracks an index representing a particular sector of the bond market or hire an active manager to try to outperform that index. While there is much debate about the advantages of both methods, we believe certain market conditions play to the strengths of an active manager, increasing the probability that they may be able to generate additional returns, less risk, or both.
When economies are transitioning from growth to recession or vice versa, the data and the outlook typically gets a bit messy. And messy is a good scenario for active managers.
While we have discussed the short term, more tactical, implications of higher bond yields, we don’t want to lose sight of something very significant that has happened: Bonds have become, after a decade or two in the doldrums, a viable asset class again.
At this point, you may be wondering if yields will go even higher. The short answer is “probably not.” Inflation has fallen significantly from its recent peak. And while it is not yet at levels the Fed would like, we think the bulk of the policy response to the sudden surge in inflation is over.
So does that mean that interest rates will fall rapidly? Again, probably not, in our view. Current consensus expects around three interest rate cuts of 0.25% in 2024, but we find that to be aggressive. Instead, we think the recent strength of the U.S. economy and the slow decline of Core inflation – which excludes the more volatile food and energy components – will encourage the Fed to be patient, keeping rates higher for longer while waiting to see how their hikes to date affect the economy.
From a broader perspective, the Fed has a variety of reasons to keep rates high. After nearly two decades of “cheap money” or low interest rates, we think the Fed feels the need to reaffirm its 2% inflation target to prevent inflation expectations from shifting higher. The Fed, in our view, has to establish a line in the sand and will defend its position.
Additionally, we think the Fed is self-conscious about its past mistakes. We believe the Fed made a clear mistake when it assumed the initial surge in inflation in 2021 would prove temporary. As such, they do not want to make the mistake of cutting interest rates too early only to see inflation tick higher, as happened in the 1980s. Nor do they want to raise rates too high, causing a deep recession. So, in our view, the Fed has every incentive to be patient.
Ultimately, we believe the Fed wants inflation lower but also wants to bring back the era of higher nominal and positive real interest rates – as in, the Treasury yield less inflation. Higher rates give the Fed greater latitude in its monetary policy and allow bonds to play their normal role in the financial system. Simply put, if the Fed gets what it wants, the recent era of ultra-low yields could prove to be the anomaly, not the new normal some investors and strategists forecast.
With nominal and real bond yields in the ranges they are today, we are back to the investment environment where bonds have more symmetrical risk – they can go down, but they can also go up. Treasuries have shifted back to their traditional diversifying role in a mixed-asset portfolio with a negative correlation to equity returns. The debate should no longer be about whether bonds have a role to play in a portfolio, but how much, what kind, and for how long?
Furthermore, we expect the persistence of higher yields will allow the diversity that stocks and bonds can offer to persist for some time. We believe this is great news for two reasons. First, it means investors who build and maintain diverse portfolios are more likely to have lower volatility, higher income, or both. Of course, diversification might help in reducing market risk, but it doesn’t eliminate it altogether, and it can’t assure a profit or protection in a declining market. But, the second piece of good news is that lower volatility may allow investors to be more confident that their net worth might survive whatever the world throws at it.
We hope this episode gave you some actionable insights into investing in bonds. More episodes of Advisor’s Market360™ are available wherever you listen to podcasts. Email us at firstname.lastname@example.org with your feedback, questions and topic suggestions for future episodes. And as always, you can learn more about us at thriventfunds.com and find other insights of interest to you, the driven financial advisor. Bye for now.
All information and representations herein are as of September 26, 2023, unless otherwise noted.
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Thrivent Asset Management, LLC associates. Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.
Past performance is not necessarily indicative of future results.
Thrivent Asset Management, a division of Thrivent, offers financial professionals a variety of investment products to help meet their clients’ needs. Thrivent Distributors, LLC is a member of FINRA and SIPC and a subsidiary of Thrivent, the marketing name for Thrivent Financial for Lutherans.