The Federal Reserve’s aggressive interest rate hikes this year have created immense volatility in the market, especially for core bond investors. As of Sept. 22, the Bloomberg Aggregate Bond Index reflected that core bonds were down 13.5% so far this year.
This experience has left some investors in a quandary about the role of bonds in their portfolio going forward: Aren’t bonds supposed to be the ballast in the portfolio, especially when there is volatility in the equities market? Is there still a benefit to holding steady with bonds, despite the headwinds that challenge them these days?
Here are some factors to consider when determining whether bonds make sense for your portfolio now:
— Higher yields make bonds more attractive.
— Outlook for bond returns is improving.
— Municipal bonds have an edge.
— Bonds may offer portfolio resilience again.
— Bonds’ role in meeting long-term goals.
Higher Yields Make Bonds More Attractive
In the three weeks ended Sept. 14, the unnerving experience in the bond market led investors to yank about $13 billion from bond mutual funds and exchange-traded funds, or ETFs, according to the Investment Company Institute. Sure, bonds have had a rough year. But has the risk paradigm shifted so much that bonds can no longer offer value to long-term investors?
Cue ESPN college football analyst Lee Corso: “Not so fast, my friend.”
As the Federal Reserve has hoisted interest rates higher this year, bond values have dipped dramatically. But this symbiotic effect has also lifted bond yields higher than they’ve been in over a decade.
“The good news is that higher yields make core fixed income more attractive, especially for investors seeking income,” says David Spika, a chartered financial analyst and president and chief investment officer of GuideStone Capital Management. With the yield on the two-year Treasury at 4.1% and climbing as of Sept. 22, “there is ample opportunity for good yield in high-quality bonds,” Spika says.
Outlook for Bond Returns Is Improving
Prior to this year, institutional expectations for core bond returns in the coming years were quite subdued — close to about 2%. That’s changed with the advent of the Federal Reserve’s interest rate hikes. For example, Northern Trust’s five-year outlooks for U.S. investment-grade bonds and global high-yield bonds are now 3.7% and 7.5%, respectively. Pimco also recently revised its five-year expected returns for bonds to an annual average range of 3% to 5%.
“Increased rates and higher income streams from core bonds have dramatically improved the probability of higher returns,” says Brian Donnelly, a chartered financial analyst and fixed income strategist for Fidelity Investments. “Long-term capital market assumptions in core fixed income returns have risen to mid single digits from low single digits since the beginning of the year. Valuations have increased across the board and made bonds viable again.”
Pay heed to credit risk, given the expectation of downward earnings revisions and modest increases in default rates, says Mike Collins, CFA, managing director and senior portfolio manager for PGIM Fixed Income. “Still, there are many attractive relative value opportunities across the global credit markets that can provide investors with attractive yields and very limited credit risk,” he says.
Municipal Bonds Have an Edge
Those who haven’t looked at yields from municipal bonds lately should do a double-take. Municipal bonds are issued by state and local governments; income from municipal bonds is exempt from federal taxes (and usually from state and local taxes for residents, as well.) At the end of July, the tax-equivalent yield on high-quality AA- municipal bonds reached 4.71%, which surpassed the yields from other bond alternatives, such as BBB+ U.S. corporates (4.33%) and 10-year Treasury yields, which surged from 2.65% up to 3.71% as of Sept. 22. This municipal tax-equivalent yield is calculated using a 40.8% tax bracket, which includes the 37% top federal marginal income tax rate and the 3.8% net investment income tax.
Many states have improved their balance sheets throughout the pandemic recovery period, which has bolstered the overall credit outlook for municipal bonds as an asset class. In fact, according to the Pew Charitable Trusts, nearly two-thirds of the states in the U.S. have collected more tax revenue in the first quarter of this year than their pre-COVID-19 growth-trajectory estimates.
Bonds May Offer Portfolio Resilience Again
The two main qualities that bonds have afforded investors over time have been consistent income and portfolio resilience. For investors who prefer a balanced investment strategy, commonly referred to as the 60/40 model (stocks and bonds), some experts project that bonds are now in a better position to deliver these two qualities, plus potentially improved returns, in the coming years.
“The current environment provides a much stronger case for the 60/40 with bond yields increasing,” says Donnelly. And if a slowdown in the U.S. economy or a recession emerges in the coming months, then it “would most likely drive correlation negative again, meaning bonds would rally if risk assets were selling off.”
Bonds’ Role in Meeting Long-Term Goals
The portfolio implications regarding bonds, especially for retirees and near-retirees, extend beyond the parameters of income, resilience and diversification. Long-range goals are also an important part of the portfolio design. Tom McCartan, CFA, principal and portfolio manager for PGIM Fixed Income, suggests that investors should focus more on “the ‘how’ of meeting long-term goals” over “the ‘how’ of managing asset volatility.”
This suggestion is also timely. The Employee Benefit Research Institute’s 2022 Retirement Confidence Survey revealed that two-thirds of Americans have less than $250,000 set aside for retirement. In a separate survey this year, BlackRock found that 64% of American savers are concerned about having enough money to last throughout retirement.
Pimco’s five-year forecast for the 60/40 portfolio allocation, a common approach for retirees, is now a return of 6% annually. Individual investors should look at how that estimate aligns with the outcome they need to sustain their portfolio and meet financial objectives. The good news is that bonds are now in a better position today to help with the heavy lifting you may need to plan well for retirement or other long-term financial goals.
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