There are no sure things in markets, but many investors believe high-quality U.S. bonds are currently pretty close.
Consensus on Wall Street is that interest rates have peaked for this economic cycle, and the pain bondholders experienced in 2022 and 2023 has likely ended. That should make further investments in Treasurys and highly rated corporate bonds a good bet, analysts and portfolio managers said, even if this year brings significant volatility across markets.
That view was tested on Friday when the monthly U.S. jobs report printed a bit hotter than expected, spurring a selloff in bonds because of concerns that inflation might persist. But then the Institute for Supply Management's services-activity index came in softer than analysts were predicting, prompting a rally that eroded bond yields' rise.
The immediate fate of bond investments lies in part in the hands of the Federal Reserve. Traders in futures markets are betting the Fed will likely lower rates at its meeting March 20, followed by another four or five quarter-point cuts throughout the year. That would be good for bonds, because lower interest rates generally mean lower bond yields, and lower bond yields always mean higher bond prices.
"Maybe we don't know how many cuts there will be, but we've never seen market yields rise going into a rate cut," said Joe Kalish, chief global macro strategist at Ned Davis Research. "For conservative investors who don't want to take a lot of risk, this is a good opportunity to tilt the odds in your favor."
Falling rates tend to boost overall bond returns. Since the 1970s, the 10-year Treasury yield has slid an average of 0.9 percentage point in the three months leading up to the Fed's first cut of an easing cycle, according to Ned Davis Research. Roughly $22.9 billion has flooded into a fund tracking long-dated Treasurys in the past year, according to FactSet.
To the extent that there is a mystery here, the question is whether bond prices have risen high enough that buying safe bonds is now a slightly riskier, at least for the near term, act than it typically is.
The 10-year yield dropped from 5% in October to below 4% after the Fed signaled its willingness to cut rates in the new year, convincing some investors that a new dawn for bonds lies ahead.
At the same time, others are wondering how much further the yield can actually be expected to fall at a time when the U.S. economy continues to expand smartly and unemployment remains near the lowest levels on record. Investors' expectation that the Fed will cut interest rates five or six times this year is roughly double what policymakers are forecasting.
"Six expected rate cuts implies the economy is nosediving, but we're experiencing more gradual disinflation," said Matt Peron, director of research and global head of solutions at Janus Henderson Investors.
Many still hope that rate cuts will help bond portfolios recover after a bruising run. The Bloomberg aggregate bond index -- a benchmark for the U.S. bond market -- lost 13% in 2022 counting price changes and interest payments, its worst year on record. Bonds spent much of 2023 in the red too, before the prospect of falling rates fueled a nearly-double-digit year-end surge, the biggest rally since the 1980s according to Dow Jones Market Data, saving them from a third-straight year of declines.
Returns in a bond portfolio come from two sources: interest payments and price changes. And prices have taken a beating lately. Bonds issued with low coupons in the era of near-zero interest rates got crushed when rates rose and newly issued debt began carrying higher payouts.
But with yields near their highest levels in decades, fans say investors can get a lot of bang for their buck.
Even if investors are wrong and rates climb more, or cuts get pushed back, rising payouts cushion against price declines, meaning those increases are less damaging at these levels than lower ones. So another climb to 5% for the 10-year Treasury yield would be less painful to investors than when yields rose from 2% to 3%.
And many of the most popular bond products these days aren't poised to benefit from rate cuts. A lot of investors hid out from the Fed's rate campaign in ultrashort-term Treasury bills and money-market funds, which invest in fixed income that matures as quickly as overnight.
Short-term assets didn't suffer hefty losses like long-duration bonds, and rates near 5.5% have made them an attractive place to stuff cash. Cuts would immediately reduce money-market funds' allure, forcing investors to contemplate reinvesting.
"There's a lot of cash that'll start to move off the sidelines this year as growth slows and central banks cut rates," said Ashok Bhatia, Neuberger Berman's co-chief investment officer for fixed income.
Write to Eric Wallerstein at eric.wallerstein@wsj.com
(END) Dow Jones Newswires
January 07, 2024 23:00 ET (04:00 GMT)
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