Central bank policy responses have had significant impacts on markets and economies around the world since the start of the pandemic. While it hasn’t been a smooth ride for investors in the post-COVID era, the silver lining may be higher bond yields. We believe these yields present interesting opportunities for investors in the years ahead.
A brief look back – 2009 through 2021:
The Federal Reserve’s response to the deflationary pressures of the 2008 Global Financial Crisis was highlighted by near a zero Fed Funds rate. The effectiveness of these policies in stimulating the economy led to the same historically low interest rate policies being implemented by the Federal Reserve (and central banks around the world) at the onset of the COVID-19 pandemic. As indicated in the chart below, the Fed Funds Effective Rate was mostly near zero from the onset of the Global Financial Crisis through the late stages of the pandemic. During this period of historically low interest rates, investors became accustomed to near zero return in low-risk investments such as money markets and certificates of deposit. Likewise, lower risk treasury bonds issued by the US government and high-quality corporate bonds alike were issued with historically low yields, providing less attractive returns for investors. While recency bias suggests that near zero rates are “normal”, they are low when compared to the historical average. The transition to higher rates proved painful for markets in 2022, but the shift toward a higher interest rate environment may be the sign of a “new normal” in the years ahead.
Higher rates ahead - 2022 and Beyond:
As many know, bond prices and interest rates have an inverse relationship – as interest rates go up, bond prices go down and vice versa. Inflation pressures which bubbled up during the post-COVID recovery spurred the Federal Reserve to raise rates at the fastest pace in history. The rapidly increasing interest rate environment of 2022 made it an extremely difficult year for fixed income investors. The Bloomberg US Aggregate Bond Index lost over 13% - its worst year in history - leaving investors skeptical of what has traditionally been a ‘conservative’ asset class used as a shock absorber within portfolios. As advisors, we find ourselves reminding clients that significant short-term drops in asset prices typically reveal attractive long-term investment opportunities. After all, when considering future returns for bonds, starting yield is [more or less] destiny. As the chart below suggests, the jarring increase in interest rates in 2022 has brought about a reversion of yields to 4-5%, like starting yields seen 20 years ago. Using historical data as a guide, this could signal stronger returns for bonds moving forward. More importantly for our clients, it marks the first time since prior to the Global Financial Crisis that we can utilize lower risk investments such as cash and bonds to meaningfully assist in achieving long-term planning goals.
Conclusion:
In the near-term, central banks around the world continue their struggle to get inflation under control while simultaneously maintaining healthy unemployment and GDP growth rates. Yet, the inflations data in the US has trended steadily downward, leaving investors hopeful that we are nearer to the end of the rate hike cycle than the beginning. This could provide a meaningful reprieve for falling bond prices, which has been evident in bond returns in early 2023. Higher yields should continue to be effective in providing steady income to investors while acting as a cushion from future rates hikes and stock market volatility. Recent data suggesting slowing economic growth and increasing unemployment figures offer investors ample reason to reconsider the role of high-quality bonds as a defensive asset class in a diversified portfolio.
This material is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation. Bonds are subject to availability and market conditions; some have call features that may affect income. Bond prices and yields are inversely related: when the price goes up, the yield goes down, and vice versa. Market risk is a consideration if sold or redeemed prior to maturity.