The Fed is finally allowing markets to set (most) rates.
Bond Concepts by Madison Investments
Undue Consternation
Many advisors and clients expressed disappointment with fixed income performance in 2024. Entering the year, expectations were high for multiple Federal Reserve rate cuts, with lower yields seemingly on the horizon. When those cuts didn’t materialize, some began questioning fixed income’s role in a portfolio. However, this reaction may be influenced by the “calendar effect” - the tendency to evaluate performance based on arbitrary time frames like quarterly or calendar-year returns. Markets don’t adhere to our timelines; they move in cycles.
Taking a step back provides a more balanced perspective. While 2024’s calendar year returns may not have met expectations, fixed income has performed well since what appears to be the peak in yields back in October 2023. It is through this longer-term lens that we believe best reflects the value fixed income can bring to portfolios going forward.
What Lies Ahead?
It’s unlikely that interest rates will drop back to the low levels seen during the Fed’s 15-year experiment with its zero interest rate policy (ZIRP) and quantitative easing (QE). Unfortunately, if you are a borrower, that means an end to free money. Investors, however, should embrace it.
The current rate environment is a prayer answered for bond investors. Historically, fixed income has served three important roles in an asset allocation: principal preservation, steady income, and portfolio risk reduction. For much of the past 15 years, the Fed’s policies—particularly quantitative easing, which artificially manipulated longer-term rates—had prevented investors from realizing these income and diversification benefits. Inflation eroded principal, the yield curve offered little income, and non-existent yields meant little buffer to volatility in other asset classes.
With the Fed normalizing short-term rates and no longer applying QE while slowly reducing its balance sheet, intermediate and longer-term rates (2 to 10 years) are back to trading more closely in alignment with economic fundamentals. In our opinion, rates are likely to trade more like the early 2000s, implying ZIRP and QE will prove to be the exception, not the rule. This doesn’t necessarily mean less volatility; it’s quite the opposite. Market sentiment can be volatile, and so can rates. We believe this volatility will create opportunities for active managers to add value through yield curve positioning, sector allocation, and quality control.
10-Year Treasury Yield
With stable economic growth and inflation sticking above the Federal Reserve’s 2% price stability target, we believe we’ve entered a structurally higher interest rate environment, similar to the range seen in the early to mid-2000s.
Positively Sloped Yield Curve – Finally
As the rates revert back to a more normal, positively shaped curve, all maturity sectors of the bond market have begun returning to their historical roles.
Cash
While we will likely see lower cash rates over the next 12-18 months, cash still offers a safe haven for short-term savings with a yield that at least keeps up with inflation. For those hoping for a better entry point in what appears to be mostly rich risk assets, it also allows you to “get paid while you wait.” The issue with cash, as always, is that it has no potential to appreciate in value. True, if the markets falter, an investor won’t lose money sitting in cash, but the lack of appreciation potential limits cash’s value as a diversification tool.
Intermediate Bonds
We believe this is the sweet spot in the domestic fixed income markets. The positively sloped yield curve finally provides a reward for taking on additional duration risk. Yields are attractive on an absolute and inflation-adjusted basis. Importantly, from a diversification standpoint, intermediate bonds have enough duration to provide meaningful capital appreciation potential should the economy weaken and rates fall.
Longer Term Bonds
Longer, aggregate-like bond portfolios also offer attractive yields, but they come with much more risk than the intermediate space. For very little additional yield, investors will be exposed to approximately 60% more interest rate risk (as measured by duration). Some investors may need longer duration exposure for asset/liability reasons, or they may just be convinced rates are heading lower and want to position in front of that move. However, for most investors, we advise caution when considering longer-maturity bonds. Breakeven analysis suggests that investors may not be adequately compensated for the risk they may be exposed to.
Breakeven Analysis Favors Intermediate Bonds
One way to measure risk when comparing bonds across durations is breakeven analysis. A breakeven analysis calculates how far rates would have to rise before the annualized total return of a bond or portfolio of bonds would turn negative. For example, at the long end, the yield to maturity on a 30-year Treasury would only have to rise approximately 30 basis points (0.30%) before price depreciation would overcome yield, resulting in a breakeven return. Any more and total returns turn negative. This compares to a breakeven of 98 bps for 5-year and 57 bps for 10-year Treasuries.
Total Annualized Return - Change in Yield
At the index level, the breakeven for the Bloomberg Aggregate Bond Index is 82 bps. In comparison, the Bloomberg Intermediate Government/Credit Index is 125 bps, and the BofA 1-5 Year Government Corporate Index is 174 bps. With inflation still running above the Fed’s 2% goal, the economy proving surprisingly resilient despite numerous challenges, and the Fed signaling a slowing pace in monetary easing, we struggle to see a scenario that would be more beneficial to long bonds, given the minimal yield pick-up. Adding to the uncertainty, potential policy shifts under Trump could further impact growth and inflation.
Spread Sectors
Last quarter, we wrote about the risks of tight spreads in bonds other than treasuries, particularly among lower quality. While it is possible that spreads could stay at these tight levels for an extended period or even tighten modestly, we think the risk/reward trade-off favors higher quality at this time. This reinforces our preference for intermediate credit exposure over the longer spread durations found in longer maturity sectors of the market.
Summary
Last year, we wrote a piece titled “Bonds are Back.” Despite a disappointing calendar 2024, we still believe that to be true. Yields are attractive and likely to remain higher for longer. With the Fed backing away from its aggressive ZIRP and QE policies, we believe fixed income markets will trade more on economic and supply and demand fundamentals rather than government intervention. That is good news for bond investors. This is not a new normal; it’s just normal. Embrace it!
BOND CONCEPTS BY MADISON INVESTMENTS
Learn the nuances of fixed income investing, including the risks, opportunities, and investment styles.