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Sticky inflation and the Federal Reserve keeping interest rates high may have dimmed the outlook for bond investors, but with a slight change in approach, there are attractive opportunities. Heading into 2024, bond investors were sitting pretty. Yields were near their highest levels in decades, offering attractive income. Meanwhile, the potential for a slowing economy and expectations for upwards of five interest rate cuts by the Fed offered potential profit from rising bond prices. Many experts advocated moving into longer-term bonds to benefit from both trends. However, continued strength in the economy and stubborn inflation have thrown a wrench in that plan. Bond yields have jumped, meaning prices have fallen, and the Fed has signaled that rate cuts won't happen until there is greater confidence inflation will resume its decline. The market no longer seems primed for a major bond rally the way it did at the end of 2023. But that doesn't mean there aren't opportunities in fixed income. Strategists point to the short end of the curve as the most attractive, and they say it's not too soon to start locking in higher yields, even if rates remain steady for the next few months. Here's everything investors need to know. The yield on the 10-year Treasury note has been steadily climbing since January as markets come to grips with a new reality. Improvement in inflation has stalled, and as a result, interest rates will likely remain higher for longer than previously thought. Some relief came in the aftermath of the Fed's meeting this week. First Chair Jerome Powell's surprisingly dovish tone appeared to reassure investors, and then better-than-expected jobs data showed inflationary pressures easing—though Morningstar chief US Economist Preston Caldwell warned that it was too soon to celebrate a cooling jobs market. The yield on the 10-year Treasury note was 4.5% on Friday—lower than October's 5.0% peak, but much higher than the market's bottom at the end of December. At that time, 10-year yields dropped as low as 3.79% on optimism that policy easing was right around the corner. Powell has been adamant that the Fed is prepared to keep rates high for as long as necessary. In turn, higher rates change the calculus for bond investors. Much of the recent rout in the bond market is attributable to a very familiar culprit. "It's inflation," says Fahd Malik, fixed-income portfolio manager at AllianceBernstein. Inflation proved much stickier than expected in the first quarter. Price pressures worsened when investors expected them to continue improving, as they had in the final months of 2023. Over three months and three-hotter-than-expected inflation prints, markets scaled back their expectations from six or seven cuts starting in March to just one or two cuts starting later this year, or maybe no cuts at all. "As the data just kept coming in month after month stronger than expected, we had to price out a lot of those cuts," says Pramod Atluri, a fixed-income portfolio manager at Capital Group. The result was a dramatic runup in bond yields and increased volatility in the days or even hours surrounding major economic data releases. The Fed has emphasized that it is "data dependent," meaning it will determine policy based on the path of the economy. Malik says this dependency has extended to fixed-income markets: "Whatever data point comes in, the market reacts." With that steady rise in yields has come several months of lackluster returns for bond investors, since bond prices tend to fall when yields rise. The Morningstar US Core Bond Index returned negative 2.4% in April, 0.8% in March, negative 1.4% in February, and negative 0.1% in January—a major turnaround from its positive performance at the end of 2023. Since the start of the year, the index has lost about 2.5%. Many strategists believe rate cuts will be limited this year, even if the economy is still on the right track with inflation. That isn't necessarily positive for the bond market. "If I'm right on the economy remaining healthy and the Fed does not cut as much as expected this year, I expect rates to be rangebound between 4%-5% in the near term," says Atluri. BlackRock's David Rogal, lead portfolio manager for the firm's Total Return, Core Bond, and Inflation-Protected mutual fund portfolios, has a similar outlook. "My expectation is that the 10-year will trade somewhere between 4.25% and 5.00%," he explains. He bases this on how inflation is still above the Fed's target and the fact that there's a lot more deficit spending from the government in the pipeline, in the form of new Treasury bonds. "I think it's biased upward from here," he says. Malik adds that more unfavorable economic data, like hotter-than-expected growth or inflation, could even push yields above 5% in the short term. Some are more optimistic. Solita Marcelli, chief investment officer, Americas at UBS Global Wealth Management, wrote in a note this week that she anticipates that 10-year notes will close the year at 3.85% as fixed-income markets recover. That forecast assumes a soft landing for the economy. A higher-for-longer rate environment—especially one in which inflation continues falling and economic growth stays healthy—could boost stocks and keep cash attractive for investors, at least in the short term. The 5%-plus yields that sent many investors rushing to money market funds and high-yield savings accounts are likely to hang around a little longer than we thought, for instance. But there are still good reasons to look to fixed income. "Stable interest rates with gradually falling inflation and economic growth of 2-3% could create an environment where investors will be rewarded for owning risk," Atluri says. "However, given the strong outperformance of risky assets over the past year, I think staying heavily invested in risk isn't prudent." Strategists say bonds are once again well-suited to offset risks in equities markets. "You can help smooth the volatility of your portfolio by introducing some bonds and doing so today," Rogal says. With rates high, "it doesn't cost you as much return as it did in the past." He adds that the hedging value of bonds will not improve if inflation stays sticky. With yields elevated, Atluri says that it's a good time for investors to reconsider duration. The Capital Group's Bond Fund of America now prefers the front end of the curve—bonds with durations of seven years and shorter. It's underweight longer-duration bonds. Duration is a measure of a bond's sensitivity to interest rate risk. It's related to a bond's maturity, but not identical. A bond with a two-year duration will be less sensitive to interest rate changes than one with a 10-year duration, since changing rates have more time to increase or reduce the latter's value. "We think this benefits the portfolio both in case there's an unexpected shock where the Fed can cut rates, or if the deficit fears resurface," Atluri says. Such a scenario would be more likely to hurt the longer end of the curve than the shorter end. Rogal also points to the federal deficit as a reason to stick with the front of the curve. The government is set to issue large amounts of Treasury debt going forward, he says, but it's not clear how smoothly the market will absorb it as the Fed runs down its balance sheet. "There's still a lot of duration risk" when it comes to longer-term bonds, he explains. At a high level, bond investors would do well to remember the central proposition of fixed income: income. While higher yields may put a dent in price appreciation, they also mean a bigger coupon payout for investors when a bond matures. Right now, strategists say inflation-adjusted yields are at some of their most attractive levels in decades. Investors can thank high interest rates for that. "Yield is the best predictor of returns going forward," Malik says. "If you can lock in yields next five to seven years at 5.5% or 6.0%, it makes a lot of sense." Rogal thinks it's a good idea to look to fixed income in the near term rather than sit in cash, even though rates aren't likely to fall any time soon: "You have to start doing some of that now because you're actually getting paid in a reasonably high-quality portfolio." Still, he cautions that a patient approach is necessary in this kind of portfolio rotation. He likes the three-to-five-year slice of the yield curve, and points to Treasury Inflation-Protected Securities as one area of the market where it makes sense to start extending. Adds Atluri: "Bond yields are now higher than earnings yields in the S&P 500. That is sending a message …that bonds are once again providing a lot of value in an overall portfolio." A strong economy tends to shrink credit spreads, and strategists say this means bond investors can take advantage of that dynamic to bolster their portfolios. "We are in a unique moment when one can upgrade their bond portfolio and not give up any yield or potential excess return," Atluri says. In other words, there isn't a large gap between the yields on lower-quality bonds and those of higher-quality, less risky bonds. He explains that while there isn't much room for high-quality bonds to outperform, there's still plenty of risk that lower-quality debt will underperform. "My rule of thumb is if you aren't paid to take risk, then don't take risk," he says. "I think now is the time to upgrade," he adds, pointing to higher-quality investments like AAA-rated agency mortgage-backed securities. The author or authors do not own shares in any securities mentioned in this article.
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