Bonds haven't been acting like bonds for years. Blame the Federal Reserve for pushing rates up to a 23-year high to combat inflation.
Have bonds provided ballast for portfolios? Nope. Have they protected and preserved capital? Nope. Have they cost investors money? You bet.
So, what's an investor to do now? Lean into bonds.
Why Bonds Still Make Sense
Say, what? Yes, all the grim news in Bondland sets the stage for better performance ahead. Investing is about the future, not yesterday's news. But it's not about timing things perfectly but rather positioning for the next leg down in yields.
Morningstar investment writer Danny Noonan summed it up best: "Abandoning bonds now might be a bit like giving up on Steve Jobs when he was ousted from Apple in the 1980s." Jobs' comeback, driven by the success of the iPhone, is now legendary. It's a big reason why Apple is one of the biggest stocks on the planet with a $3 trillion market value.
The financial pain in the bond market is well known. The Bloomberg US Aggregate Bond Index has suffered a peak-to-trough decline of more than 17% since peaking in August 2020, says Noonan. That double-digit decline is akin to what you'd expect in a stock market swoon, not the normally boring bond market.
Asset Class Action In Bonds
But no asset class stays down forever. And when you consider the high starting point of yields (many bond yields are at their highest levels in more than 15 years) — and odds that the Fed's next move will be to cut rates not hike them further — the outlook for fixed-income brightens.
"There is still a high correlation between a bond fund's performance and starting yields," said Lawrence Gillum, chief fixed income strategist at LPL Financial.
Another plus: today's current high yields act as a buffer, or income cushion, which helps offset any near-term price declines, says Saira Malik, chief investment officer at Nuveen.
The Fed's Moves
On Wednesday, the Fed opted to keep its key rate (the Fed Funds rate) unchanged at 5.25% to 5.5%. And, as expected, the central bank dialed back the number of possible rate cuts this year from three to one.
Nonetheless, with rates of high-quality bonds now in the 5% to 6% range, bond investors now have the luxury of "compounding that interest for a longer period of time, which is a great tailwind" said Leslie Falconio, head of fixed income strategy at UBS Global Wealth Management.
Better Returns Going Forward For Bonds
Despite the gloom in fixed-income markets, bonds are currently UBS' "most preferred asset class." And it's not just about plump yields, Falconio says. It's also very much about the prospect of getting price appreciation on bonds once the Fed starts to cut rates.
Bond prices move in the opposite direction of yields. So, if yields come down, prices on bonds will rise, netting investors a solid total return from the combination of the yield the bond pays and capital appreciation.
Falconio, though, is pragmatic. She isn't positioned for a big fall in rates anytime soon. Nor is she positioned with the thought that inflation will quickly fade and return to the Fed's 2% inflation target. But she's not betting on a reflationary environment that will push rates up, either. "The path for the Fed Funds rate is lower," said Falconio.
Don't get caught up on whether the Fed's first rate cut will come in September, November or December. Take advantage of the yields offered now and set your bond portfolio up to benefit from bonds rising in value when rates eventually fall.
Taking A Barbell Approach With Bonds
Instead, she's positioning bond portfolios to benefit from the high yields. She's focused on short-term bonds (debt with maturities from 1 to 3 years) due to the inverted yield curve and a higher-for-longer rate regime.
But she's also making a bet on bonds in the "belly of the yield curve" (bonds that mature in three to seven years) to take advantage of solid yields and the chance for capital appreciation if and when the economy slows, inflation weakens, and the Fed starts its next rate easing cycle.
"We're structuring the portfolio with a barbell approach," said Falconio.
Focus On High Quality
Falconio advises bond investors to focus on high-quality bonds. That includes investment grade corporate debt, municipal bonds issued by cities and states, as well as agency mortgage-backed securities (MBS). MBS are pools of residential mortgage loans securitized and issued by U.S. government agencies like Freddie Mac and Fannie Mae. She likes short- to intermediate-term Treasuries, too.
"These higher-quality bonds, given where we are in the cycle, are the place to be," said Falconio.
And when it comes to interest-rate risk, better known as duration, she says the sweet spot now is duration of roughly five years. That's a tad less than the six-year duration of the benchmark bond index. The reason: the portfolio is not taking excessive interest rate risk. It also positions the portfolio in the belly of the curve with bonds that, she says, will see a more sizable yield drop when the Fed cuts than bonds of other durations.
Looking More Long Term?
Falconio is not bullish, however, on longer-term bonds, such as ones with maturities of 10 years or more. "We're not getting compensated enough," she says. She says the bond market is a show-me market. And she says longer-term bonds won't move much until the Fed actually makes the first move to lower rates.
Using TIPS, or Treasury Inflation Protected Securities which generate real returns of 2% to 2.5% above inflation, is another way to hedge against risks. Risks include a spike in energy costs due to geopolitics. That could cause inflation to remain elevated, adds Falconio.
Funds that could be used to mimic Falconio's strategy include Vanguard Short-Term Bond Index (VBISX). It has a duration of 2.66 years and holds bonds that mature in one to three years, according to fund-tracker Morningstar. To gain a little more rate sensitivity, a portfolio like Vanguard Intermediate Term Bond ETF fits the bill. The ETF has a duration of 6.22 years and the effective maturing of the bonds it owns is 7.3 years, says Morningstar.
Lock In High Yields On Bonds For Longer
Another option to lock in today's sizable yields for longer is to purchase bonds directly and hold them until maturing, says LPL's Gillum. "Hold them to maturity if you can. And just collect the coupons (or regular interest payments)," said Gillum.
Like Falconio, Gillum also likes high-quality agency MBS debt for its yield and quality. "These triple-A rated mortgage-backed securities are yielding 5% to 5.5% and there's very little credit risk or default risk," said Gillum.
No doubt, cash is still attractive with the top yields offered by partners of Bankrate.com reaching close to 4.9%, adds Gillum. The problem is cash yields will tumble as soon as the Fed starts cutting rates. But bonds offer better optionality, adds Gillum. If yields go sideways, you'll earn more on bonds. And when yields start to decline, you'll also earn extra on a bond's appreciation.
Rates Lure Buyers
"Rates look attractive at these levels," said Charlie Ripley, senior investment strategist at Allianz Investment Management. "We're not too concerned about interest rates moving higher. (For now), I think you're getting most of your return from the rate side of the picture."
Bond investors could benefit from a contrarian streak now, and buy what's not been working: bonds, says John Lloyd, portfolio manager and lead for multi-sector credit strategies at asset management firm Janus Henderson.
"Find opportunities in asset classes that have not yet rallied (like the S&P 500 has)," said Lloyd. "The conditions for bonds to outperform are firmly in place and rates have not yet moved to reflect that, creating opportunity for investors."
