The Bond Market: Fixed Income's New Reality

Lawrence Gillum:

It's Midyear Outlook release day here in LPL Research, and we could not be more excited. The theme for this release is called "Still Waiting on the Turn", which expands on our initial 2024 Outlook, A Turning Point. This midyear update offers fresh insights into the economic and market landscape, along with the potential impact on investment portfolios. And while I'd love to be able to cover everything in the Street View video, today's video will be on, well, what else? The fixed income markets and the big themes we expect to play out over the next few quarters. But be sure to check out the broader Midyear Outlook piece on lpl.com.

Lawrence Gillum:

Market pricing for Fed rate cuts has been volatile this year, which has meant bond prices have been volatile as well. We currently expect the Fed to cut rates this year by 0.5%, with more rate cuts likely coming in 2025. But while markets continue to wait for rate cuts, a lingering question remains, how low will the Fed be able to take the fed funds rate absent a financial crisis? The answer to that question has major ramifications on the overarching shape of the U.S. Treasury yield curve, and by extension, the ability for longer maturity Treasury yields to fall meaningfully from current levels during this Fed rate cutting cycle. The first chart is probably my wonkiest chart, but arguably the most important. Current market pricing, which is the squiggly light blue line, suggests the Fed will only take the fed funds rate back to around 4% or so before stopping its rate cutting campaign.

Lawrence Gillum:

If that is true, the 4% fed funds rate will keep longer maturity yields from falling meaningfully from current levels. And perhaps paradoxically, that is a good thing for fixed income investors and savers because that keeps income levels elevated. And income has been the most important contributor to fixed income total returns. With the Fed seemingly unlikely to lower interest rates until after the summer months, at the earliest, the higher for longer narrative has kept a lid on any sort of bond market rally. And while falling interest rates help provide price appreciation, in this current environment fixed income investors are likely better served by focusing on income opportunities, which has been the traditional goal of fixed income investors anyway. For many financial markets, the primary driver of total returns is price appreciation. You buy a stock, for example, and total returns are largely predicated on the price of that stock going higher,

Lawrence Gillum:

though dividends play a role. For bonds, it's different. This chart shows the breakout between price returns, which are the light blue line and index total returns, which is the dark blue line. The difference between those two lines is the contribution from income. And since the inception of the Bloomberg Aggregate Bond Index, over 90% of total returns have come from the income component, with the remainder coming from price appreciation. Right now, investors can build a high-quality fixed income portfolio of U.S. Treasury securities, AAA-rated agency, mortgage-backed securities, and short maturity investment grade corporates that can generate attractive income. Investors don't have to reach for yield anymore by taking on a lot of risk to meet their income needs. And finally, let me start by saying cash is no longer trash. Cash is absolutely back as a legitimate asset class again, particularly for those investors that have a time horizon measured in a few quarters or even a few years.

Lawrence Gillum:

But there's an optionality that you get from bonds that you don't get from cash. While current yields for bonds and cash are similar, bonds offer portfolio protection and potential price appreciation if an unexpected event negatively impacts the economy that you just don't get from cash. So if we're wrong about the economy and it slows more than we think it will, the Fed may in fact cut interest rates more than markets are expecting, which would be beneficial to fixed income investors. And in the meantime, you can clip coupons and generate attractive income with bonds. Now, over the past 40 years, bonds have averaged around 6.1% annually versus a 3.5% return for cash. And bonds have been consistent outperformers. So with cash rates likely to fall as the Fed cuts rates, bonds have done a better job than cash at helping investors grow their assets over the long term.

Lawrence Gillum:

While we certainly think cash is a legitimate asset class again, unless investors have short term income needs, they may be better served by reducing some of their excess cash holdings and by extending the maturity profile of their fixed income portfolio to lock in these higher yields for longer. So the bottom line, the focus for fixed income investors should shift back to the traditional benefit of bonds, which is income. Current high starting yields offer attractive risk adjusted returns even without significant price appreciation. Additionally, bonds can help reduce overall portfolio volatility compared to stocks. With the Fed likely to begin cutting rates in the second half of 2024, investors should consider using bonds to replace some excess cash holdings. And by moving into high-quality fixed income, investors can lock in these attractive yields for longer and fortify their overall portfolios. Thanks for listening, and make sure you check out the full Midyear Outlook piece on lpl.com. Take care.