Income to Reward Investors

Since our last update, bond market volatility remains front and center, as Fed policy remains paused.

Charts 1 & 2: 0:22– As you can see with this chart of the 10-year Treasury, for much of the year, the bond market has experienced a bumpy path higher in yields, and this has been driven primarily by lingering inflation concerns, strong employment gains and a hawkish Fed. However, during May, Treasury yields declined, and this was driven in part by soft payroll data and consumer spending, while the CPI [consumer price index] signaled inflation pressure may be easing. While it’s notable that this decline in yields has continued through the first week of June, yields are still broadly higher across the curve from where we started the year.

And despite the volatility, we continue to believe the underlying economy remains in good shape and economic growth will continue to be driven by a more measured consumer as higher interest rates, slower job gains and depleted savings start to have an impact. As a result, we continue to forecast zero to two rate cuts from the Fed this year.

Charts 3 & 4: 1:18– In our view, a more guarded Fed has been one factor contributing to U.S. Treasury yields remaining higher than where we began the year. And as we look out to the remainder of 2024 and into next year, we forecast 10-year yields to remain above 4% despite Fed easing. The charts above are one core reason why: on Chart 3, because of ongoing budget deficits, over $3 trillion in Treasury issuance is expected over the next five years.

Chart 4 shows how the buyer base of U.S. debt has been changing, as foreign holders have reduced exposure. While domestic buyers like households, banks and mutual funds have picked up the slack and now represent nearly 50%, the uptick in supply will lead to additional price sensitivity. Taken together, this supports an extended “higher-for-longer” theme and will continue to provide opportunities across markets.

So what does this mean for fixed income investors? Well, it’s hard to ignore yields that remain at decade highs, and with Fed policy approaching a turning point, the risk-reward trade-off from holding fixed income is well balanced. This means that for short-term cash investors with liquidity needs, short-term bonds remain attractive, with Treasury yields between 4.85% and 5.4%.

Chart 5: 2:39– For investors with an extended time horizon, we continue to favor buying longer maturities, as the high levels of income we are seeing are an important source of forward returns that can help cushion the impact of interest rate volatility. To help understand this, we ran the Bloomberg Intermediate Corporate Bond Index through three different interest rate scenarios to estimate forward returns.

If rates remain unchanged over the following 12-month period, bond valuations should remain stable, and total return will likely be driven by yield. Or in other words, the income received is projected to result in a return near 5.3%.

Should rates increase by 1% over the next 12 months, we would expect to see some price depreciation as bond valuations decline, but the income received over this time period should more than compensate for this, and total return would still be positive. Should rates decline by 1%, income and price appreciation would combine for an estimated return near 8.7%.

The key takeaway is if yields move up or down, the distribution of returns remains positive across all scenarios. And the next move from the Fed likely being a rate cut argues for extending maturities. We believe the high levels of income provided by the corporate and municipal bond markets now offer an attractive opportunity for investors. This can help adjust the characteristics of your portfolio in ways that weren’t possible over the past 10 years when yields were much lower.