The Fed pause could be an “almost generational” opportunity for bond investors

Bonds are having a moment. With the Federal Reserve expected to be at the end of a rate-raising cycle, investors are re-evaluating the fixed-income market — and looking to high-quality medium-maturity bonds as their best bet for a stable income.

Investment-grade corporate bonds now yield about 5%, up from about 2.8% two years ago. Such huge returns protect bonds against the possibility of negative total returns if the experts are wrong and the Fed continues to tighten.

In fact, bond professionals believe that the total potential return of bonds this year exceeds the return of stocks. For fixed-income investors, this will be a welcome change from last year, when US bonds lost 13% on a total return basis.

“Now that we’re through the dark tunnel, we’re seeing the end – and it’s sunny outside,” says Benoit Ann, chief strategist for the Investment Solutions Group at MFS Investment Management. “The stars have now lined up for a stable income to do well in the coming period.”

In June, the Fed is expected to pause – meaning to keep interest rates steady, after raising them at every meeting since March last year. Kristi Akolian, chief strategist at iShares at BlackRock, says the bond market may determine in 2023 interest rate cuts that may not materialize. Instead, investors could see typical evidence of a pause, as the Fed keeps interest rates steady until at least the end of the year.

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Since 1990, the Fed has paused an average of 10 months between the last rate hike and the first cut per cycle, according to a BlackRock analysis. Each time, the bond market initially rose, then experienced volatility as a downgrade approached.

This climate offers a “nearly a generation” opportunity in fixed income, Akolian says. The overall return potential is greater now than it will be when the Fed starts to loosen up. Interest rate cuts will boost bond prices and reduce yields, killing total future returns.

A good point in the yield curve is three to seven years, says Akolian, as opposed to last year, when the short end of the curve was more attractive. “It’s not a bad thing to have some time right now,” says Jack Janasiewicz, portfolio manager at Natixis Investment Managers Solutions. Returns with a shorter maturity are best when inflation is hot and rates are rising quickly.

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Janasiewicz says investors who accumulate three-month Treasury notes at around 5.2% should remember that this is the annualized yield. To achieve this, you’ll need to reinvest your T-bill at the same rate three more times when it comes due. Given that rates could drop next year, he agrees with Akkolian that maturities of three to seven years are the strongest option.

Exchange traded funds such as

iShares Core US Gross Bonds

(Ticker: AGG) High-quality US bonds are on the belly of the yield curve. The average yield to maturity is 4.33%. This fund includes Treasury bonds; Showing companies only

iShares iBoxx Investment grade corporate dollar bonds

ETF (LQD) now yields 5.03%.

With junk bonds offering rates of 8% or so, it can be tempting to venture into high-yield territory. But with a possible recession – and the resulting rise in defaults – they are fraught with danger.

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As bonds outperform, liquidity loses some of its luster. BlackRock found that historical data shows that cash exposures return on average less than the underlying bond and short-term bond exposures when the Fed stops tightening. From 1990 to early 2023, exposure to underlying bonds performed 4% better than cash equivalents on average when the Fed held or cut rates, while high-quality short-term bonds performed 1.9% better than cash.

“The extra weight of cash was the big story last year,” says Anne. “But it all ends.”

write to Elizabeth O’Brien at [email protected]

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