With inflation-adjusted interest rates firmly in positive territory, bonds remain a good choice for income and portfolio diversification. Investors can now benefit from taking on more interest-rate risk in bonds with shorter and medium-term maturities rather than cash. Bonds have also recently become more attractive to the stock market on a risk-adjusted basis, as equity valuations and the stock market have continued to rise.
The aggressive rate recalibration by the Federal Reserve since September, combined with a reduced likelihood of a recession, recently put upward pressure on long bond yields. A stronger-than-expected economy has pushed longer-term bond yields higher. When recession fears subside, investors are less inclined to buy Treasuries as a hedge to portfolios, favoring equities.
This has caused some recent recalibration of asset allocation, with bonds becoming incrementally more competitive relative to equities over the last few months. It is possible, however, that the current environment may continue to support the equity markets in the near term while the bond market may experience more volatility as investors adjust to a recalibration for still higher rates. This creates an attractive entry point opportunity for investors who have been considering new positions in bonds or increasing their allocation to the asset category.
Chair Powell’s recent remarks highlighted the tension between a strong economy and the Fed’s tightening stance, leaving investors questioning the trajectory of rates and growth. Rising long-term rates are a byproduct of monetary policy and reflect broader fiscal dynamics. Increased Treasury issuance to finance deficits and lingering inflationary pressures introduce additional risk premiums into the bond market.
Many believe forecasts for a strong economy mean that yields aren’t likely to fall further, even if it’s widely agreed among investors and analysts that more rate cuts are coming through the end of the year and into 2025. Rates, particularly long-term rates, may not come down significantly from here barring any changes to the forecast for strong economic growth. Much of the impact of rate cuts has already been priced into the market so it wouldn’t be surprising to see yields trade in a range. It seems that the 10-year note may remain in a range between 3.75% and 4.25%, and potentially 4.50% on the higher end.
While higher yields can now be found along the yield curve, investors should be cautious about too much exposure to long-dated bonds—especially given forecasts of robust economic growth in the months ahead. A spot in the middle of the curve may be more prudent because long-term economic expectations tend to affect long-term rates more than shorter ones. To avoid this volatility but retain high yields, investors should look to bonds with two-, three-, five- and seven-year maturities.
Risk assets in the fixed-income world look attractive today. In the bond market, this means corporate credit rather than government bonds. Lower interest rates generally equate to lower borrowing costs for businesses, which means better profitability, better credit conditions, and less refinancing risk. This is a change from the bond rout in 2022, when persistent inflation turned investors bearish on bonds as they braced for higher rates for longer. In an environment like that, Treasuries were safer than riskier asset classes like corporate bonds.
For high earners, yields on tax-advantaged municipal bonds look very attractive. On the taxable side, seek higher-quality investment-grade credit over lower-quality high-yield credit and consider corporate bonds and structured products over government bonds. In a world where the economy continues to grow and the Fed is easing, you still want to be exposed to sectors. Investing in higher-quality credit may be especially important now because, with valuations compressed, the additional return you get from high yield versus investment grade is on the low side. A recession would mean that higher-risk fixed-income categories, including high-yield bonds, could significantly underperform their higher-quality counterparts.
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David Rosenstrock, CFP®, MBA, is the Director and Founder of Wharton Wealth Planning. He earned his MBA from the Wharton Business School and B.S. in economics from Cornell University. He is also a CERTIFIED FINANCIAL PLANNER™.