The tide has turned for bonds. Here’s what we think is in store for 2024.
2023 was a year of transition for the global economy and financial markets. As extreme inflation subsided, investors’ attention shifted to slowing growth and prospects for rate cuts. The resulting rollercoaster ride included a surge in bond yields, with the 10-year US Treasury yield briefly touching 5% as
technical conditions clouded the fundamental picture.
By November, however, the tide had begun to turn. Sidelined cash flooded back into the market, rapidly driving yields down and prices up. We don’t think the rally has run its course, though—we’re optimistic for 2024.
Yields to Trend Lower
Key central bank rates and bond yields remain high globally and are likely to remain elevated well into 2024 before retreating. Further, the chance of higher policy rates from here is slim; the potential for rates to decline is much higher.
In the euro area, for example, after years of negative yields, AAA-rated 10-year German Bunds currently yield 2.0%. Meanwhile, inflation in the region is heading back toward target. Given weak expected growth, the European Central Bank may need to ease midyear.
In the US, where inflation—while declining—is still well above the Federal Reserve’s target, we expect rates to remain elevated into the second half of 2024. Given current trends in economic data, we think the Fed has completed its rate-hiking cycle and will remain on pause until inflation is closer to 2%, when it can begin to ease in the face of cooling US growth. Despite Treasuries’ recent rally, yields remain very compelling, with the US 10-year Treasury now yielding 3.9%.
For bond investors, these conditions are nearly ideal. After all, most of a bond’s return over time comes from its yield. And falling yields—which we expect in the latter half of 2024—boost bond prices. Investors should consider extending duration in this environment to gain exposure to rates.
Not All Late-Cycle Environments Are Alike
It’s true that sustained higher rates are likely to lead, eventually, to a turn in the credit cycle. Rate hikes are already weighing on activity in many sectors. Corporations have continued to beat earnings expectations, but not as impressively as earlier in the year. Some companies have noted that consumers are spending less. Indeed, households have already spent much of their savings accumulated during the pandemic. Leverage is creeping higher, and interest coverage—the ratio of a company’s EBITDA to its total interest payments—has begun to decline.
But because corporate fundamentals started from a position of historic strength we’re not expecting a tsunami of corporate defaults and downgrades. Plus, falling rates later in the year should help relieve refinancing pressure on corporate issuers.
Strategies for Today’s Environment
In our view, bond investors can thrive in today’s favorable environment by adopting a balanced stance and applying these strategies:
1. Get invested. It’s not too late to join the bond party. If you’re still parked in cash or cash equivalents in lieu of bonds—the “T-bill and chill” strategy made popular in 2022—you’re losing out on the daily income accrual provided by higher-yielding bonds, as well as the potential price gains as yields continue to decline.
2. Extend duration. If your portfolio’s duration, or sensitivity to interest rates, has veered toward the ultrashort end, consider lengthening your portfolio’s duration. As the economy slows and interest rates decline, duration tends to benefit portfolios. Government bonds, the purest source of duration, also provide ample liquidity and help to offset equity market volatility.
3. Hold credit. Yields across credit-sensitive assets such as corporate bonds and securitized debt are higher than they’ve been in years, giving income-oriented investors a long-awaited opportunity to fill their tanks. But credit investors should be selective and pay attention to liquidity. CCC-rated corporates and lower-rated securitized debt are most vulnerable in an economic downturn. Long-maturity investment-grade corporates can also be volatile and are currently overpriced, in our view. Conversely, short-duration high-yield debt offers higher yields and lower default risk than longer debt, thanks to an inverted yield curve.
4. Adopt a balanced stance. We believe that both government bonds and credit sectors have a role to play in portfolios today. Among the most effective strategies are those that pair government bonds and other interest-rate-sensitive assets with growth-oriented credit assets in a single, dynamically managed portfolio. This kind of pairing also helps mitigate risks outside our base-case scenario of weak growth—such as the return of extreme inflation, or an economic collapse.
5. Consider a systematic approach. Today’s environment of weakening economic growth also increases potential alpha from fixed-income security selection. Active systematic fixed-income investing approaches, which are highly customizable, can help investors harvest these opportunities. Systematic approaches rely on a range of predictive factors, such as momentum, that are not efficiently captured through traditional investing. Because systematic approaches depend on different performance drivers, their returns will likely differ from and complement traditional active strategies.
Get In and Get Active
Active investors should stay nimble and prepare to take advantage of shifting valuations and windows of opportunity as the year progresses. Above all, investors should get off the sidelines and fully invest in the bond markets. Today’s high yields and potential return opportunities will be hard to beat.