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09/26/2023

Bonds: Time to shift out of park

Close-up of a driver's hand on a gear shift

Key points

What will the Fed do?

Interest rates are unlikely to rise much further or fall quickly.

Portfolio changes to consider

Investors may want to consider rotating from cash to Treasuries and/or corporate bonds.

Think long-term returns

Bonds are again a viable asset class: Investors may want to return to more balanced portfolios.


WRITTEN BY:
Chief Investment Strategist
WRITTEN BY:
Steve Lowe, CFA,Chief Investment Strategist

The welcome return of yield

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 — from some of the more sensational talking heads — the value of government bonds in a diversified portfolio.

And then the previously unthinkable thing happened. Inflation surged higher and faster than it had in forty years — hitting levels not seen since the late 1980s. The U.S. Federal Reserve (Fed) had no choice but to respond with commensurate aggressiveness by raising interest rates at a speed and magnitude not seen since the Great Inflation.

Figure 1: 50 years of inflation and the Fed

Chart depicting inflation and Fed funds target rate.

Will yields keep going higher?

Probably not. Inflation (see Figure 1 above) has fallen significantly from its recent peak. While it is not yet at levels the Fed would like, and thus one more hike is likely and further hikes are certainly possible, we think the bulk of the policy response to the sudden surge in inflation is over.

This does not mean rates will fall rapidly. Rather, we view the current consensus for roughly three 0.25% interest-rate cuts in 2024 as 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.

The Fed has sundry incentives to keep rates high

After nearly two decades of “cheap money” or low interest rates, and much criticism for it, 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 as happened in the 1980s, only to see inflation tick higher. Nor do they want to raise rates too high, causing a deep recession and confirming an often-made criticism that the Fed only knows when it has raised rates far enough when it has killed the economy. 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. (The “real” interest rate is 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 (negative in some parts of the world) yields could prove to be the anomaly, not the new normal some investors and strategists forecast. Thus, in our view, the Fed has every incentive to be patient in the quarters ahead, keeping rates as high as they can for as long as they can to ensure inflation is defeated.

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Portfolio changes to consider in the short term

We believe yields on most bond asset classes are now high enough to be attractive on an absolute basis. The yields that could be locked in for the life of a bond across the major fixed-income asset classes are compelling relative to their recent history, relative to current inflation, and to the current economic environment. As such, we believe it is time for investors to reconsider their bond allocations. To help with that, we have five suggestions:

1. Reconsider your cash allocation

Many investors have built up larger cash positions over the past few years, understandably 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 and you have to re-invest the money. While holders of, for instance, a three-year bond won’t have the problem for three years, holders of money market funds or various “cash plus” exchange traded funds (ETFs) will start to see the problem as soon as rates start to fall.

What could you do with the cash?

2. Consider short-duration securities

Short-maturity securities, like the three-year bond mentioned above, issued by either the U.S. Treasury or high-quality companies, allow investors to lock in higher yields for longer. Additionally, they could experience some capital appreciation. If the Fed does cut rates later next year, the yield curve should steepen, with the short end falling faster than the long end. As can be seen in Figure 2 below, the yield curve today is severely inverted (two-year Treasury bonds today pay around 0.7% more than a 10-year bond), so the effect could be significant. 

Figure 2: The U.S. Treasury yield curve is severely inverted

3. Take a dip in the deep end: Long-duration Treasuries

We think longer maturity (10 years and longer) Treasury bond yields 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 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. Figure 3 below shows the likely total return of a 10-year bond when held for a year, across a range of yields at the end of that year. Note the asymmetry in returns: A 10-year Treasury bought at a yield near 4.5% today would likely still generate a positive (albeit small) return if its yield rose 0.5%, ending the year at 5.0%. But if rates fall, the same bond could gain around 8% if its yield fell the same 0.5% over the period.

Figure 3: Implied 1-year returns of a 10-year U.S. bond

4. Consider owning more investment-grade corporate bonds

Corporate bond markets also offer attractive yields insofar as 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 (below investment grade) market, we are not convinced that they adequately compensate for the risks if the economy stumbles for longer than expected. 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. As can be seen in Figure 4 below, U.S. investment-grade corporate bonds currently offer slightly more than 0.8% additional yield than 10-year U.S. Treasuries, while short-term investment-grade corporates offer a further 0.18%. Like the cushion we illustrated (in Figure 3 above) provided by higher U.S. Treasury yields, the additional yields offered by corporate bonds can provide further protection against rising interest rates, and a potentially more attractive upside should yields fall.

Figure 4: Likely returns in corporate bonds across a range of changes in yield

5. Favor active over passive management

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. There can be more opportunities in security selection (e.g. a company simply gets overlooked) and/or more sophisticated relative value or hedging strategies (e.g. taking advantage of the cushion higher yields provided to allow somewhat larger allocations while still meeting risk targets). 

Additionally, volatility in the various bond markets has been relatively high since the Fed started raising rates. This is appropriate considering the high levels of uncertainty investors have had to tolerate. But, as the economy slows and we move from a period of wondering whether the Fed will raise, pause, or cut rates, to asking not if but how fast the Fed will cut rates, volatility will likely drift lower.

And when volatility falls, active managers can often find attractive relative value opportunities, such as overweighting cheaper securities and underweighting the more expensive ones, expecting both sets will ultimately converge. Another example: When volatility is high there can be a substantial premium paid for less liquid bonds. But as volatility falls, that premium typically fades. For all the advantages passive index funds offer, they simply cannot seize the occasional high-quality opportunities to add value.

Think about long-term returns

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.

Over the long term, a bond’s yield is generally the most significant portion of its future total returns. As yields have fallen since the 1990s, so have the returns of the benchmark Bloomberg U.S. Aggregate Bond Index, from an average annual return near 7.7% in the 90s, to 6.6% in the 2000s, to just 3.8% from 2010-20191. And while the percentage of that return which was derived from yields falling (capital appreciation) rose, the bulk of the returns remained dominated by the bond’s yield. Now that rates are back to (roughly) where they were in the 2000-2009 decade, chances are good total returns will look more like they did in that decade than the last decade.

To be fair, the current period of higher yields, owing to the sudden surge in inflation, could prove to be a blip. It could last just the decade that a 10-year bond issued today is good for, and we slip back to the world of the previous decade when many argued that secular tailwinds were leading us to a new world of zero (or negative) interest rates.

Those arguing for “structurally” lower rates had good points: Globalization and especially the full entry of China and other emerging markets into the global economy proved to be a strong deflationary force, especially through cheaper goods. Additionally, the need to pay down debt after the housing bubble and the subsequent global financial crisis, particularly by U.S. consumers, but also in Europe more broadly, added to the deflationary tailwinds. But the winds likely are shifting to structurally higher rates due to deglobalization — driven in part by geopolitics — as well as massive investment into decarbonization, aging demographics, and high public sector deficits. 

Finding the balance

With nominal and real bond yields in the ranges they are today, we are back to the investment environment of our youth (or for our younger readers, your parents) when bonds had more symmetrical risk (they could go down, but they could also go up). Treasuries have shifted back to their traditional diversifying role in a mixed-asset portfolio with a negative correlation to equity returns. That’s because rates typically fall with poor economic news, increasing the return potential of bonds. On the other hand, equities typically decline on poor economic news as it has negative implications for earnings. 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. As a reminder, while diversification can help reduce market risk, it does not eliminate it. Diversification does not assure a profit or protect against loss in a declining market. Second, lower volatility may allow investors to be more confident their net worth will survive whatever the world throws at it.

This is more valuable than you might think. A 2021 Bank of America study showed that panicking is more damaging to your portfolio’s health, while patience more beneficial than most of us imagined.  If you invested in the S&P 500 Index in 1930, and stayed invested through 2020, you would have made a 17,715% return. But if you were out of the market for the 10 strongest days in each decade your total return would be just 28%. It pays to be invested, and to stay invested.

And to stay invested, we understand you need to have confidence in your portfolio. To get there, we encourage investors to start taking a more proactive role in their bond investing. It may still be early to shift into second or even third gear, but if you are still in park, we think it’s time to get moving.

 

 

Media contact: Callie Briese, 612-844-7340; callie.briese@thrivent.com

1 Source: Bloomberg Index Services Ltd. As of 12/31/2022.

All information and representations herein are as of 09/26/2023, 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.

S&P 500® Index is a market-cap weighted index that represents the average performance of a group of 500 large-capitalization stocks.

Bloomberg US Aggregate Bond Index is an index measuring the performance of U.S. investment grade bonds.

Any indexes shown are unmanaged and do not reflect the typical costs of investing. Investors cannot invest directly in an index.

Past performance is not necessarily indicative of future results.

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