The Bond Market Update: What You Need to Know
Written by: Steven Fraley, CFA, MBA and Austin Cleveland
Congratulations to baby boomers for hitting the investment scenario lottery! You weathered both the dot- com bubble of the early 2000s and the global financial crisis, each of which presented opportunities to buy stocks at bargain prices. In the years that followed, you benefited from exceptional equity returns. Now, as your focus may be shifting to retirement, the environment is again working in your favor. You can achieve nearly 5% yields on cash, and bonds offer a much better outlook than they have over the last 15 years.
For many years, equities were the only game in town, or certainly the best. Large cap growth stocks dominated the narrative and bond yields weren’t getting anyone excited. On top of that, investors got crushed in 2022, with a high-correlation drawdown for both stocks and bonds. When the Federal Reserve began hiking interest rates in 2022, the correlation between stocks and bonds hit its highest level in 15 years. This resulted in the third-worst year ever for a 60/40 portfolio (60% S&P 500/40% Bloomberg Aggregate Index), only surpassed by two years during the Great Depression.
Figure 1: Rolling prior 12-month correlations of returns between $SPY and $AGG (Data source: Morningstar)
What’s next for the relationship between stocks and bonds? While stock/bond correlation remains above the 20-year average, Innovest does not expect this to persist. Research from AQR Capital Management demonstrates how stocks/bond correlation tends to decrease when economic growth news dominates and increase when inflation concerns prevail. With inflation as a major investment risk over the past few years, this likely drove higher correlation. With inflation now moderating, we anticipate stock/bond correlation to decline, allowing both asset classes to return to their roles as portfolio diversifiers.
We view fixed income both as an important diversifier, offering stability and income during market volatility, and as a ballast, providing resilience across the broader asset allocation. Our long-term investing approach focuses on generating alpha through detailed security analysis and selection, thoughtful risk management, and yield curve positioning. We prioritize strategies that demonstrate the ability to generate strong risk-adjusted returns across various market cycles.
Several factors make fixed income an attractive asset class today. Bond yields have risen, inflation has moderated, domestic equity valuations are elevated, and the Federal Reserve is poised to begin cutting interest rates, which could further boost bond returns. As of September 9, 2024, the yield-to-maturity (YTM) on the iShares Core US Aggregate Bond ETF stood at 4.20%. By contrast, over the last 10 years, ending June 30, 2024, investors in the iShares Core US Aggregate Bond ETF earned only 1.31% annualized, due to the low interest rates of the 2010s. With the Fed’s longer-run expectations for interest rates at 2.75%, bond investors are in a far better position today than in the past decade.
Research from JPMorgan Asset Management supports the idea that starting yields are highly predictive of future returns. Given the current yield of 4.20%, we can reasonably anticipate a forward 5-year return of approximately 4.28% per year.
Figure 2: (Source: JP Morgan Asset Management)
Over longer periods, yield becomes the primary driver of bond returns. According to research from PIMCO, while short-term price movement in response to interest rate changes can affect bond performance, long-term investors should focus more on yields as the key determinant of returns.
Figure 3: (Source: PIMCO)
With inflation calming after persistent high levels seen globally in 2022 and 2023, fixed income inflation risk has declined. Fixed-rate bonds offer fixed coupon payments and lose value when inflation rises. However, as inflation moderates and the Federal Reserve shifts towards cutting rates, the outlook for bonds improves.
As we anticipate rate cuts from the Fed, it is important to consider how lower interest rates will impact different asset classes. Yields on money market funds will quickly decline, requiring investors to look further out on the yield curve. Research from BlackRock shows that US core bonds have averaged a 7.2% return in the year following the first rate cut while money market funds have averaged a 4.2% return. Data from PGIM reveals that the earnings yield on stocks (the inverse of the P/E ratio) has fallen below bond yields for the first time in over a decade, suggesting bonds may offer a more attractive relative value going forward.
Figure 4: (Source: PGIM Fixed Income)
The vast fixed income market comprises over $140 trillion in bonds across corporate, government, municipal, and securitized issuances. Given this opportunity set, Innovest leans into active management and multisector strategies to capture opportunities. With their flexible mandates, multisector managers can adapt to changing market conditions and capitalize on attractive opportunities in the bond market that passive investors, limited by the index, might miss.
After years of relatively low yields and challenging market conditions, the outlook for bond investors has improved dramatically. With higher starting yields, easing inflation, and an anticipated shift in monetary policy, bonds offer a compelling blend of income generation and diversification benefits within a portfolio.