By Tim Courtney, Chief Investment Officer
During the past decade, bonds generally haven’t been very appealing to own. Due to central bank actions, we saw interest rates kept very low, dropping to zero at one point.1 Central banks also held yields low by purchasing large amounts of bonds. Some markets actually experienced negative bond rates,2 meaning you had to pay issuers for the privilege of owning bonds. It was a long, strange trip for bond investors.
Up until last year, broad bond returns were fairly consistent and positive, but the low rates assumed virtually no risk of inflation. When inflation did finally arrive in 2022, it wiped out a decade of returns in broad bond markets. The broadest bond indexes returned only 1.0% annualized for the decade ending 12/31/2022, while inflation averaged 2.60%. Stocks, while also experiencing a pullback when rates rose in 2022 still provided a meaningful real return – 9.9% after inflation – over the decade.3
After several back-to-back interest rate hikes by the Federal Reserve, we’re returning to a more typical and healthy market, where bonds offer an expected rate of return that at least accounts for some inflation risk. In the current market, investors can earn 3%-5% for higher-quality bonds,4 bringing us much closer to the traditional relationship between bonds and stocks. This means actually getting paid a decent yield to compensate for the risks (default, interest rate increases and inflation) of owning bonds.
The bond and futures markets are now telling us they believe the Fed will soon end rate hikes and that rates will actually start falling this year. The bond yield curve’s current inversion means that short-term bonds are offering higher yields than long-term bonds.5 This is an odd situation where the reward is actually greater for taking on less risk, and it’s happening because the bond market thinks short-term rates will soon fall.
Another indicator that rates might begin declining is the widespread belief that some type of recession will occur in 2023.6 It’s important to listen to the market, which tells us what the aggregated sum of all investors think. The market gives us helpful information through prices. But we also need to remember that markets don’t always forecast the future correctly.
We’re happy that interest rates now enable investors to earn a more solid return on bonds, so we recommend owning a diversified spectrum of bonds. A diversified bond portfolio includes both short and intermediate-term bonds. If you have any questions, please contact your Exencial advisor.
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