The Federal Reserve’s 11 hikes to the federal funds rate since March 2022 — from essentially zero to a current range of 5.25% to 5.5% — have tested investors’ resilience. Core, U.S. investment-grade bonds declined by around 13% in 2022 and are only up about 1.6% year to date through the end of August, according to data from BlackRock. The prices of bonds fall as interest rates rise.
[Sign up for stock news with our Invested newsletter.]
This experience has left some investors in a quandary about the role of bonds in their portfolios going forward: Aren’t bonds supposed to be the ballast in the portfolio, especially when the equities market is volatile? Is there still a benefit to holding steady with bonds, despite the headwinds that challenge them these days?
The Best Opportunity in 20 Years?
Apparently, some bond investors’ unnerving experiences over the last 18 months have dampened their convictions about the fixed-income asset class. For example, the Investment Company Institute recently reported investors’ net inflows to taxable bond mutual funds and exchange-traded funds, or ETFs, totaled about $1.3 billion, while their net withdrawals from municipal bond holdings reached $706 million for the week of Sept. 6 through Sept. 13. By comparison, investors added more than $17.8 billion to U.S. equity mutual funds and ETFs in the same period.
Has the risk paradigm shifted so much that bonds can no longer offer value to long-term investors?
Not exactly.
Sure, bond valuations plummeted as the Federal Reserve lifted rates. But the prospects for higher yields have also improved for long-term investors. “The bond market is today as compelling an opportunity as any time in the past 20 years. Nominal government bonds like U.S. Treasurys offer high enough yields at almost every maturity to generate long-term compounding potential, strong positive total returns and useful diversification versus stocks, all the while presenting low credit risk,” Jeff Moore and Michael Plage, fixed-income portfolio managers for Fidelity Investments, said via email.
[9 of the Best Bond ETFs to Buy Now]
Improved Outlook for Bonds
Back in 2021, institutional expectations for core bond returns in the coming years were quite subdued, at around the 2% mark. That’s changed. For example, Northern Trust’s 10-year annualized return forecast for U.S. investment-grade bonds and global high-yield bonds is now 4.7% and 7.2%, respectively. BlackRock also revised its 10-year expected returns for fixed income to an annual average range of 4.2% to 5.2% for U.S. aggregate bonds, and 6.3% to 8% for global high-yield bonds.
The Federal Reserve Bank of St. Louis currently projects a median federal funds rate of 5.1% in 2024, followed by a median rate of 3.9% in 2025. These projections suggest inflation will continue to abate in the coming months and years, a process presumably accompanied by an economic slowdown in the U.S. — both of which are historically favorable scenarios for bond prices. In fact, following the last four rate hike transitions from 1995 to 2018, core U.S. bonds experienced average annual one-year returns of 10.1% and five-year returns of 7.1%, according to data from the Capital Group and Morningstar.
Julia Hermann, multi-asset portfolio strategist at New York Life Investments, suggests several fixed-income strategies for the road ahead. “High-yield corporate bond exposure is not a traditionally favored area in a slowing economy, but may offer a compelling yield/price opportunity in this cycle. This space has already seen a drawdown consistent with the early 1990s recession and dot-com bust, but spreads are in a historically moderate range. A balanced approach to duration, such as pairing short-duration, high-yield bond exposure with longer-duration municipal bond exposure, can help investors diversify core bond exposure while keeping time horizon and credit risk close in hand,” Hermann said.
Attractive Income From Municipal Bonds
It’s hard to look away from money market funds when they can provide a safe current yield of around 5%. But for investors who are looking for competitive yield beyond 2023, municipal bonds may be worth a second glance. For example, data from Raymond James indicates national municipal bonds (10 to 20 years in maturity) currently have an average yield to worst of around 3.95%. This equates to a taxable equivalent yield to worst of close to 6.65% for individuals in the top federal tax bracket and subject to the net investment income tax. Yield to worst is a measure of the lowest possible yield on a bond that is within its contract terms and does not default.
Outcomes Still Matter
Still, portfolio implications regarding bonds — especially for retirees and near-retirees — extend beyond the parameters of income, resilience and diversification. It’s wise to integrate goals and outcomes in a portfolio design, too.
There’s a growing need among American workers to reevaluate their current savings and investment strategies for retirement. The Employee Benefit Research Institute’s 2023 Retirement Confidence Survey revealed that 64% of Americans with a retirement plan have less than $250,000 set aside for retirement. In a separate survey this year, Schroders found only 24% of Americans near retirement age believe they have saved enough.
J.P. Morgan’s 2023 forecast for the 60/40 portfolio allocation of equities and bonds — a common approach for retirees — calls for a 7.2% annual return. How does that estimate align with the outcome you need to sustain your portfolio? The good news is bonds are now in a better position to help with the heavy lifting you may need to plan well for retirement or some other important financial objective.
More from U.S. News
7 Best Funds to Hold in a Roth IRA
7 Best Vanguard Funds for Retirement
Why Bonds Make Sense for Your Portfolio Now originally appeared on usnews.com
Update 09/28/23: This story was previously published at an earlier date and has been updated with new information.
