More than a year of interest rate hikes by the Federal Reserve has pushed bond yields to levels not seen in more than a decade. With the Fed possibly coming to the end of rate increases, should investors be looking to increase their bond exposure?
Bond yields have risen
For most of the past 15 years, interest rates have hovered near historical lows. The Fed cut interest rates following the 2008 financial crisis and inflation remained muted, which allowed the Fed to keep rates at low levels.
When the Covid-19 pandemic hit the economy in March 2020, the Fed again followed a similar playbook: cut interest rates to stimulate the economy. By August 2020, the 10-year Treasury yield sat close to 0.50 percent.
But as the economy recovered from the pandemic shock, inflation also picked up steam. By March 2022, when the Fed first began to raise interest rates, inflation had reached 8.5 percent, according to Department of Labor data. In an attempt to slow the economy and combat high inflation, the Fed has raised interest rates at a swift pace, bringing its key rate to roughly 5.4 percent as of November 2023.
The rise in rates hurt bond prices throughout 2022, with the Bloomberg U.S. Aggregate Bond Index falling 13 percent for the year, the worst bond performance in decades. Bond prices and yields move in opposite directions, meaning prices fall as yields rise, and vice versa.
But with the Fed signaling a potential end to its tightening, some investors now see an investment opportunity in bonds that hasn’t existed for more than a decade.
Is now a good time to buy bonds?
Many investors have been reluctant to hold bonds for years due to the low interest rate environment, but that should no longer be the case, says Collin Martin, fixed income strategist at Charles Schwab.
“Any decision to increase the bond allocation is up to each individual investor, but investors who have been sitting in cash waiting for higher yields don’t necessarily need to wait anymore,” Martin said. “Adding bonds to a portfolio provides diversification benefits, and today they offer some of their highest yields in years.”
Ryan Linenger, a Chicago-based financial advisor with Plante Moran, sees an opportunity to lower overall portfolio risk through bonds, without sacrificing much in the way of returns.
“Higher expected returns for bonds means a client could consider paring back some on risk assets (like stocks) and increasing their allocation to bonds while still delivering solid overall portfolio returns,” Linenger said, while acknowledging that allocation decisions always depend on the needs of the individual client.
Reinvestment risk
One challenge presented by the current environment is the inverted yield curve, which means long-term yields are lower than short-term yields. Normally, investors would demand higher yields to lend their money for longer time periods, but that’s not the case currently.
This phenomenon may cause investors to favor short-term bonds over long-term bonds, but the decision isn’t as simple as it may seem. While short-term yields are higher currently, they’re also more sensitive to Fed policy, which means these yields may fall if and when the Fed starts to cut rates.
“Once the Federal Reserve begins to cut rates, yields on short-term investments should begin to fall, and investors may be faced with lower yields when their maturing bonds come due,” Martin says. “Intermediate and long-term Treasury yields are still near their highest levels in 15 years, so we’d rather lock in those high yields with certainty rather than risk reinvesting at lower yields once the Fed does begin to cut rates.”
Steer clear of high-yield bonds
Investors looking to capture additional yield may be attracted to the high-yield bond market, where average yields are around 9 percent as of October 2023. But both Martin and Linenger suggest investors exercise caution when it comes to these bonds of risky borrowers.
“We’re concerned that high-yield bond prices could fall over the next six to 12 months, and possibly enough to offset the high yields they offer,” Martin says. “High-yield bonds are rated ‘junk’ for a reason—they tend to have a lot of debt and weaker balance sheets than investment grade issuers.”
Linenger says many investors may have held high-yield bonds over the past decade as a way to boost their yield in a low-rate environment, but with a potential recession looming, he thinks these riskier bonds could suffer.
“With economic growth showing signs of a slowdown, and financial conditions and lending standards already tight, the risk-reward trade-off doesn’t seem as compelling today,” Linenger says. “Since bonds tend to be a client’s safety net in times of volatility — we prefer higher-quality bonds today.”
Bottom line
Ultimately, the decision on whether or not to hold bonds and in what amount will depend on the unique circ*mstances of each individual investor. But the rise in interest rates has made bonds more attractive than they’ve been in over a decade. Investors can now earn attractive rates on short-term cash through money market funds, while longer-term bonds present an opportunity to lock in yields in case rates fall.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.
As a financial expert with a comprehensive understanding of the current economic landscape, I can provide valuable insights into the article's concepts related to the Federal Reserve's interest rate hikes and their impact on bond yields.
Firstly, the article discusses the historical context of interest rates over the past 15 years. The Federal Reserve, in response to the 2008 financial crisis and the 2020 Covid-19 pandemic, employed a strategy of cutting interest rates to stimulate economic growth. However, as the economy recovered and inflation surged, the Fed initiated a series of interest rate hikes starting in March 2022.
The rise in interest rates had a notable effect on bond yields. The relationship between bond prices and yields is inversely proportional—when interest rates increase, bond prices tend to fall. This phenomenon was evident in 2022, with the Bloomberg U.S. Aggregate Bond Index experiencing a 13 percent decline for the year, marking the worst bond performance in decades.
The article raises the question of whether the current juncture presents an opportune time for investors to increase their exposure to bonds. Financial experts, such as Collin Martin, a fixed income strategist at Charles Schwab, suggest that the prevailing circ*mstances offer a unique investment opportunity. The rationale is based on the fact that bond yields are at levels not seen in over a decade, following the Federal Reserve's tightening cycle.
Furthermore, the experts emphasize that the decision to invest in bonds depends on individual circ*mstances. Investors who have been cautious about holding bonds due to the prolonged low-interest-rate environment are now urged to reconsider. Adding bonds to a portfolio is seen as providing diversification benefits, and the current environment offers some of the highest yields in years.
The article also addresses the concept of reinvestment risk, particularly in the context of an inverted yield curve. The inverted yield curve implies that long-term yields are lower than short-term yields. Despite the appeal of higher short-term yields, investors are cautioned about the potential sensitivity of these yields to Federal Reserve policy changes. The suggestion is to consider intermediate and long-term Treasury yields, which are still near their highest levels in 15 years.
However, the article advises caution regarding high-yield bonds. While the high-yield bond market may offer attractive average yields of around 9 percent, experts such as Collin Martin and Ryan Linenger express concerns about the risks associated with these bonds. High-yield bonds, often rated as 'junk,' tend to be issued by companies with weaker financial positions, and the experts suggest exercising caution, particularly given the potential for price declines.
In conclusion, the decision to invest in bonds and the specific types of bonds will depend on individual investor circ*mstances. The article provides a nuanced perspective on the current economic conditions, emphasizing the attractiveness of bonds after a prolonged period of interest rate hikes. However, it also highlights potential risks, such as reinvestment risk and caution regarding high-yield bonds, urging investors to conduct thorough research and consider their unique financial situations.
