By Ian Salisbury
Investors are preparing for the Federal Reserve to cut interest rates for the third time in a row on Wednesday -- which should provide a tailwind for bonds. You wouldn't know it from looking at bond prices, which have tumbled sharply in the past week. Fortunately, there are still plenty of opportunities for investors willing to take on some risk.
It wasn't supposed to be a difficult time for bonds. The Federal Reserve's rate-setting committee meets for the final time in 2024 later this week. Investors widely expect policy makers to lower the benchmark federal funds rate by a quarter percentage point to 4.25% to 4.5%. That normally provides a lift to bond prices, which move in the opposite direction to interest rates.
It will be the Fed's third rate cut since September. So far, however, those cuts haven't sparked much of a bond rally, at least when it comes to long-term bonds which have seen rates rise, not fall, even as short-term rates come down. The yield on the 10-year Treasury note surged to 4.4% on Monday from 3.7% before the Fed's first cut in September. It has jumped 0.2 percentage points from 4.2% in the past week alone.
All this has led to tepid bond fund returns. The iShares Core US Aggregate Bond exchange-traded fund, an index fund designed to capture the broad bond market, has returned just 2% this year, despite yielding about 4.3%, as falling prices ate into the value of the fund's payouts.
What gives? Part of the bond market's malaise can be chalked up to over-rosy expectations. While long-term bond prices have fallen recently, they climbed through much of summer as traders anticipated the Fed's first cut. But there are other factors too -- and these have led to a realization on Wall Street the Fed ultimately won't be able cut rates as deeply as investors once hoped -- curtailing generous bond market returns in 2025.
The economy -- as measured by hiring and corporate profits -- is "humming along," while inflation is no longer falling and has become stuck just below 3%, says Michael Rosen, chief investment officer of Angeles Investment Advisors. What's more, he adds, investors may soon have to contend with trillions more in deficit-driven spending from Washington. That could exert upward pressure on both prices and interest rates. "Put all this together and it suggests to me that interest rates are not likely to move a lot lower than where they are," he says.
Bonds do have one advantage heading into next year. Today's comparatively high yields -- compared with the 1% to 2% payouts from a few years ago -- provide some cushion for bondholders. To many investors that makes bonds look attractive compared with stocks, which are trading at higher price-to-earnings ratios than anytime since the late 1990s.
Given stocks' lofty valuations, Cresset Asset Management forecasts the S&P 500 to return just 4.9% annually over the next decade. That's just below the 5.3% yield investors can lock in today on 10-year triple-B rated investment corporate bonds, says Cresset Chief Investment Officer Jack Ablin. Given corporate bonds also tend to be far less volatile, they look pretty attractive, Ablin adds. "Relative to equities, bonds are fairly priced," he says.
Investors looking for bigger returns, need to take bigger risks but they have options too. The SPDR Bloomberg High Yield Bond ETF yields 6.9% with relatively low sensitivity to interest rates at a three-year effective duration.
Junk bonds aren't cheap. The spread -- or the extra interest in junk to investment-grade bonds -- is at the lowest level in more than a decade. It shouldn't be a deal breaker, according to Carl Kaufman, co-CEO of Osterweis Capital Management, which manages junk funds.
"In 2018 and 2019 spreads were a lot wider than they are today," he says. "But that's because we were getting 5% in high yield, and 1.5% in investment grade."
Investors can minimize risk by sticking with higher-rated double-B bonds, which are close to the cutoff for investment grade, and so-called fallen angels, like those in the VanEck Fallen Angel High Yield Bond ETF. Research shows these types of bonds tend to outperform native junk bonds in the long run.
Even juicier yields are available for investors willing to venture into outside traditional bond markets into private credit. While many private credit vehicles are available only to "accredited investors" who meet SEC wealth requirements, so-called interval funds like Cliffwater Corporate Lending Fund and Apollo Diversified Credit are open to general investors. Both offer yields of more than 9%.
Investors need to approach these funds with caution, says Mercer Advisors Chief Investment Officer Donald Calcagni. High fees, restrictions on withdrawals, and the use of leverage, or borrowed money, which magnifies gains -- and losses -- are all potential drawbacks. Still, says Calcagni, they have become popular with the firm's advisors and clients. "There are absolutely risks," he says. "But you have to weigh them against the risks of buying equities at 30 times earnings."
Write to Ian Salisbury at ian.salisbury@barrons.com
This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.
(END) Dow Jones Newswires
December 17, 2024 01:00 ET (06:00 GMT)
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