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Is the bond market a buy yet?

Sandy Ward  |  25 Jul 2022Text size  Decrease  Increase  |  
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While the Federal Reserve Board is on track to raise the federal-funds rate yet again this week, an unlikely investment could start providing some shelter from the storm: long-term bonds.

This might be the last place anyone would dream of seeking refuge after the carnage that has occurred this year in fixed-income portfolios, and at a time when sentiment has soured so significantly on bonds thanks to inflation holding in at four-decade highs and the Fed’s aggressive rate hikes. Prices on long-term government bonds are particular sensitive to changes in interest rates.

But the global push to raise interest rates, which is expected to see the US Federal Reserve, the Reserve Bank and others send rates north of 2% by year end, is also leading to signs of an economic slowdown and raising worries about the potential for a recession. In the upside down world of the bond market, that’s potentially good news.

“With the Fed sticking to its hawkish guns amid an economy that’s already slowing—housing and manufacturing data are slowing, jobless claims are rising and consumer sentiment is near all-time lows—a rocky landing-recession scenario is building,” says Steve Chiavarone, senior portfolio manager and equity strategist at Federated Hermes, a Pittsburgh-based money-management company with $631 billion in assets under management.

“One area that could benefit is longer-term Treasuries, where yields may have peaked on increasing recession odds,” Chiavarone says.

Morningstar’s US Treasury Bond Index is down 20.11% this year on a price basis as its yield has risen to 2.77% from the lowest point ever in August 2020, according to Morningstar manager research strategist Eric Jacobson.

Two weeks ago, the yield on the 10-year stood at 3.09%. At the start of this year it was at 1.63%. Bond prices move inversely to yields. Treasury yields have declined recently as concerns about an economic slowdown have risen.

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“If fed-funds probabilities tell us what the market thinks the Fed will do, yields for Treasury notes with several years to maturity give a sense of how successful the market expects those efforts to be,'' explains Jacobson. “Put another way, the lower those yields, the more confident the market is that the Fed’s rate hikes will work in taming inflation.” 

Are bonds a buy right now?

“It is becoming increasingly clear that the only path for the Federal Reserve is to tame inflation by bringing down demand,” says Michael Contopoulos, director of fixed income at Richard Bernstein Advisors, an independent investment research firm in New York City. “And growth, not inflation, is the biggest driver of longer-dated bond yields. The 10-year Treasury yield can reach a cyclical peak even with very elevated levels of inflation.”

Contopoulos adds, “Although we doubt the 10-year yields have reached their apex for this cycle, we are probably closer today than at any time over the last two years.”

For investors traumatized by this year's returns and are afraid of potential losses, know that the yield on the 10-year would have to increase to 4.3% in the next two years before you would realize a mark-to-market loss on the investment, he says.

“Although this is possible, if we enter a recession between now and then, and yields fall to 1.5%, the returns stand to be between 17% and 23%,” Contopoulos says. The risk reward profile has shifted, he notes, “creating an opportunity for us that we have not seen in some time.”

Historically, bonds have typically proved to be a good diversifier in portfolios and provided a cushion to stock market volatility. Not this year. For the second time in four decades, bonds and stocks posted losses for two straight quarters and the so-called 60/40 balanced portfolio structure, of 60% equities and 40% bonds failed miserably.

But Ricky Williamson, portfolio manager and head of US outcome-based strategies for Morningstar Investment Management, thinks that dynamic could be changing back to the old relationships where bonds do a better job of protecting portfolios.

“The 10-year-yield is almost twice as high as it was to start the year,” says Williamson. The rise in yields on the longer-term Treasuries have “reignited the potential for the diversification benefits of high-quality bonds in a traditional recession if we begin to see inflation get under control. We have begun to see value in owning more Treasury duration to offset equity risks if the economy disappoints.”

The Federal Reserve Board is widely expected to stay aggressive in raising the benchmark fed-funds rate when it meets next week, as it moves to rein in inflation running at the hottest pace in 40 years.

The magnitude and duration of the hikes will determine whether the Fed can successfully achieve the so-called soft landing it seeks, slowing down the economy without tipping it into recession. Or not.

Australians looking for exposure to longer-duration bonds can check out gold-rated PIMCO Global Bond or Janus Henderson Australian Fixed Interest.

Sandy Ward is a markets columnist for Morningstar.com

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