Perspective for the Year Ahead: Bonds

Telemus Weekly Market Review December 11th - December 15th, 2023

It has been quite a year for bond investors. A mere two months ago we were thinking 2023 would mark the third straight year of negative returns for the asset class. As November began, a sharp plummet in yields created a rally in bond prices, to a point where bonds are able to break the trend of consecutive down years. 

The wild ride for bonds these past two months is emblematic of what the bond market has been like the last couple of years. For much of the back half of 2023, the volatility of the bond market has been greater than overall stock market volatilityⁱ. When comparing the last two years for bonds, the difference comes down to the maturities driving the volatility. In 2022 a greater portion of the volatility in interest rates came from shorter term bonds, or those with maturities of two years or less. At that point, the market was adjusting its expectations of where the Federal Reserve was going in raising its overnight funding rate, the federal funds rate. Since this is a short-term measure, the shorter end of the Treasury yield curve was most impacted. In 2023, expectations moved out to not only when the Fed would stop hiking rates but when it might cut, which began to impact longer maturities. Therefore, interest rate volatility in 2023 was more pronounced among longer dated bonds. 

Despite bank runs earlier in the year and episodes of concern around the trajectory of the economy, both investment grade and high yield corporate bonds are closing out the year with yields that are tighter relative to Treasuries than where they were at when the year began.  An economy that has held up better than expected despite the sharp rise in interest rates over the last two years, and stable corporate earnings have helped to hold up the demand for corporate bonds. Default rates on corporate bonds, however, have begun to see a modest uptick. This is a trend we expect will continue to gradually climb in the year ahead. 

Amidst the volatility in interest rates, we have noticed some mispricing of risk within select sectors of the bond market. One area that stands out are mortgage-backed securities, or securities issued by government housing agencies such as Fannie Mae and Freddie Mac. Because of the swift move higher in yields, mortgage back securities range from offering coupons (interest payments) from as low as 2% to over 6%. Demand between the various coupons has ebbed and flowed over the year, creating opportunities for bond investors to garner some added value from security selection within this sector.  

Outlook

The bond market has a reputation of being less exiting that stocks. Over the past year we’ve found ourselves analyzing and discussing the bond market a lot more than in recent years.  It is anything but dull these days and with 2024 shaping up to be a year where investors focus on ‘how much and when’ in terms of Federal Reserve rate cuts. This debate is likely to support bonds remaining a rousing asset class. 

We anticipate volatility will remain in the bond market as speculation around future actions out the Federal Reserve will drive adjustments in Treasury yields. However, during the last two months of 2023 maturities five years and longer experienced roughly a full percentage point drop in yieldⁱⁱ. In our view, the late 2023 move put a degree of speculation on Fed rate cuts that we believe overexaggerates likely Fed policies. 

At this point it’s too early to say when the Federal Reserve will cut interest rates. In our view, the Fed is cognizant of errors made in the 1970’s when rates were cut too early, and inflation came roaring back. If the labor market remains strong, and unemployment remains below 5%, we don’t see a need to cut rates. However, along the way the Fed could elect to make a couple of small cuts to signal a willingness to balance stable employment while seeking to contain inflation. Regardless, Fed moves are going to be data dependent and one can’t be too reliant on one scenario or another before seeing the data to prove it out. Given this, we would expect 2024 to be a year where there will be a lot of ‘noise’ in movements in rates. As such, we don’t believe investors need to react and follow rate movements that may be too aggressive or overly cautious based on short-term reactions to economic data. 

A positive stemming from the rising rates of 2022 and 2023 are more attractive yields offered in the bond market. The bond market barometer, the Bloomberg U.S. Aggregate index, currently offers a yield of 4.6% , its highest year-end yield in 15 years. As we look to the next year, given the uncertainty around the direction of the federal funds rate, we are more focused on a bond portfolio’s carry, or the yield produced by the bond portfolio. Relative to much of the past fifteen years, investors can earn a reasonable level of carry from their bond portfolio and should emphasize this rather than short-term movements in bond prices stemming from the speculation on the timing and cadence of Fed actions. 

On the corporate bond front, we are encouraged by the stability in corporate earnings and strong cash flow generation. We acknowledge, however, that higher interest rates will gradually wear on borrowers, particularly when their debt matures. As a result, we expect the default rate to gradually climb, however we do not yet see signs that we should expect an elevated default rate in 2024. Looking out over the next several years, we expect higher rates to lead to an above-average level of default rates and thus prefer any high yield exposure be in issuers with higher credit ratings.

A risk factor we are paying increased attention to is the amount of Treasury bonds expected to be issued in 2024. An elevated federal government deficit is a key contributor to this. In addition, over the last year the Treasury has elected to increase the number of short-term Treasury bills it issues, thereby leading to a greater percentage of debt rolling over each year. A third factor that could influence the supply and demand of Treasuries is the Federal Reserve’s quantitative tightening program where it lets $60 billion a month of Treasuries mature. As bonds on the Fed’s balance sheet mature, the debt is effectively being refinanced as the Treasury issues a new bond to replace the maturing bond, with the broader bond market having to absorb the new bond as the Fed elects to sit out buying any additional Treasuries. This equates to $720 billion per year or additional supply for the market to absorb given what is rolling off the Fed’s balance sheet. Collectively the supply of Treasuries issued in 2024 is likely to be significantly greater than demand experienced in previous years. We view this as a risk that the Treasury may have to ultimately auction off Treasuries at higher yields than are currently priced in the market to entice enough buyers. 

We view the potential supply/demand challenges in Treasury bonds to be a risk to higher rates in 2024, but one where the probability is hard to handicap. When we consider this risk alongside the potential for fed rate cuts, which could lower bond yields, we think it’s prudent to be closer to neutral with exposure to interest rate risk, preferring to take risk elsewhere, such as in adding exposure to sectors of the market that we believe offer more attractive relative return potential. 

Looking beyond the taxable bond market, municipal bonds are not starting 2024 with as great of an allure. An incredibly bullish market in the fourth quarter has led to less attractive relative values for municipal bonds in comparison to Treasuries. A lack of supply late in the year, combined with surprising demand, has pushed prices higher. We expect the recent reduction in yields to propel new issuers to market. This should equate to improving supply as we work through the first quarter. We’d expect relative valuations of municipal bonds to improve at that time. However, to start the year we are more cautious and fastidious in the prices we elect to pay on municipal bonds. 

The year ahead appears more optimistic for bond investors given the attractive yields presently offered. There remains a range of outcomes and we expect the noise associated with speculation around future fed actions to sustain the elevated volatility in the bond market. Looking through the noise, and earning the yield on the bond portfolio, is in our view the best approach to investing in bonds in 2024. 

iBond Market volatility as measured by the MOVE index. Stock market volatility as measure by the CBOE VIX Index.

iiSource: Bloomberg. As of December 15, 2023

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