Investors were looking for some relief in 2023 from the bond bear market. But the Federal Reserve’s four interest rate hikes chipped away at short-term bond prices…and a stronger-than-expected economy sent long-term US Treasury bonds—typically regarded as one of the world’s most trustworthy assets—spiraling down another 13%.* Result: As of November 2023, the total bond market was headed for a third consecutive year of negative returns.
Bond fund strategist Robert M. Brinker knows how brutal it has been for fixed-income investors, especially those who depend on bonds to provide ballast and security for their portfolios. But with the very worst of the carnage over, Brinker says this isn’t the time to abandon bonds. In fact, today’s entry point is the most opportune it has been in a decade.
Bottom Line Personal asked Brinker to discuss the outlook for bonds this year, as well as which types of bond funds to avoid and which ones are likely to do well…
I’m optimistic for the first time in years because the Fed has finally reached the end of its rate-hiking cycle. If you invest in bonds now, you are getting the highest yields in years—the 10-year US Treasury topped 5% for the first time since 2007—plus interest rates could start to fall in the next few years, pushing up bond prices and igniting a strong rally in fixed income. Several factors support this sunny outlook, including…
Interest rates have likely peaked. With tamer inflation and less vigorous economic activity, I think the short-term federal funds rate has seen its high in the 5.25% to 5.5% range. In 2024, I expect the Fed to make modest cuts to shore up growth in the economy, with a short-term rate of 5% or lower by year-end. Meanwhile, 10-year Treasury yields are unlikely to rise much above 5% and could drop back down under 3.5%. Added bonus: If we do have a recession, long-term Treasuries will provide a nice cushion because stock investors will flood into them for safety and push up their prices.
Inflation will drop below 3%. As of November 2023, inflation as measured by the Consumer Price Index was 3.2%. While it is unlikely that we will reach the Federal Reserve’s long-stated target of 2%, that doesn’t preclude the Fed from trimming rates amid an economic slowdown since it also will consider other factors such as the unemployment rate and how risks to the global economy and the banking industry can affect the US economy.
The economy will slow—but we will avoid a recession or experience only a very mild one. Elevated short- and long-term interest rates will work to slow economic expansion in 2024, but consumer and government spending is just too buoyant to have a deep recession. I expect annual growth of 2% in 2024 gross domestic product (GDP).
Some bond investors may prefer to sit out 2024, keeping their money in cash equivalents such as money-market mutual funds and one-year US Treasury debt securities, often referred to as T-bills. Both now offer better deals than longer-maturity bonds with virtually no worry of losses.
My take: It’s a great strategy for conservative investors who aren’t ready to jump back into bonds or who might need the cash in the near future. But cash equivalents face significant “reinvestment risk” if you plan to stay in fixed-income for the long term. If the Fed cuts rates this year and beyond, you will have to reinvest at lower yields. Also, historical data shows that long-term Treasuries have consistently outperformed shorter-dated ones immediately after the last in a series of interest rate increases by the Fed. On average, they returned 10% over six months after the Fed funds rate peaked.
These categories have limited upside in 2024 and could expose you to losses…
Floating-rate funds own bondlike securities such as bank loans made to corporate borrowers. Unlike most bonds, these very short-term, adjustable-rate loans don’t have a fixed payout rate. Instead, the rates reset every 30 to 90 days so the securities keep pace if interest rates rise. They thrive in a rising-rate environment, and 2023 saw them surge. But these funds tend to do poorly when interest rates fall. They also are exposed to default in a slowing economy since floating-rate loans are made to low credit-quality borrowers.
High-yield (junk) bond funds. These speculative-grade bonds issued by companies with sub-par balance sheets were a surprising bright spot in the 2023 bond market because the strong economy kept defaults at bay. But don’t let the 8.5% yields on junk bonds fool you. The headwinds this asset class faces are starting to accelerate. Even if we avoid a recession, financial conditions and lending standards already are tight, and default rates for highly indebted companies are likely to rise. The extra yield you get by buying junk bonds over Treasuries of similar durations isn’t nearly high enough to compensate for the added credit risk.
The following are my favorite bond funds now because they have the most promising outlooks this year, including attractive yields, relatively low chance of losses and potential for some capital gains.**
iShares TIPS Bond ETF (TIP). Many investors find Treasury Inflation-Protected Securities (TIPS) difficult to understand, but they offer an excellent opportunity now, especially for retirees who want to protect their spending power from inflation. Here’s why: The yields on these bonds are derived from a formula that includes a base rate that the government pays plus the rate of inflation. Two years ago, the base rate was negative. Currently, the base rate is 2.5% on a 10-year US Treasury, the highest it has been in two decades. With inflation still elevated, you are now earning yields in the 7% to 8% range on TIPS. This exchange-traded fund (ETF) offers simple, low-cost diversification, holding about 50 different TIPS notes. Recent yield: 6.42%. Performance: 1.74%. iShares.com
Vanguard Long-Term Treasury ETF (VGLT). It might seem counterintuitive to buy longer-maturity bonds when they actually yield less than short-term government debt. But extending your maturities makes sense now. Reason: If yields fall from their current elevated levels, long-term bonds will see strong price appreciation. According to Rosenberg Research, with yields at 5%, the 10-year Treasury note would have a total return of 8.5% over the next year if yields fall 0.5 percentage points. At the same time, if yields increased 0.5 percentage points, investors still would see a total return of 1%, since price declines would be propped up by interest payments. This ETF holds about 80 bonds with maturities typically between 15 and 30 years. Recent yield: 4.77%. Performance: 1.05%. Vanguard.com
Vanguard Wellesley Income Fund (VWINX) is a hybrid offering that typically holds about 60% of its portfolio in US government bonds and investment-grade corporate bonds…and around 35% in blue-chip, dividend-paying stocks such as JPMorgan Chase and Pfizer. That strategy has proved remarkably stable. In the fund’s 53-year history, it has had only eight years with losses, none of them more than 10%. Even in a tougher economic environment, stocks of high-quality companies should have a decent year because the businesses can continue to grow revenues and profits. Recent yield: 3.41%. Performance: 4.92%.