It was supposed to be a banner year for bonds. Instead it has been a bust so far. But the rest of the year could be more fruitful, if you know where to look.
The U.S. bond market is once again proving to be a minefield. Falling prices have pushed bond total returns down an average 3% this year, and no area of the market has been spared—even “junk” bond total returns are barely in positive territory, on average, despite yields topping 7%.
Many analysts expected better. The story heading into the year was that the Federal Reserve would cut interest rates sharply, giving bonds a tailwind. Falling rates generally push down yields and lift prices, leaving investors with both capital gains and interest income.
Yet yields have inched up on dimming prospects for rate cuts. Consumer price increases have proven tough to get down, recently coming in at an annualized 3.5%, and with inflation still a problem for the Fed, prospects for rate cuts have dimmed. Traders see just a 22% chance of a cut at the Fed’s meeting in June, down from 51% a month ago, and it’s debatable if the Fed will even lower rates at all this year. Heading into the year, markets were counting on up to six quarter-point cuts in the federal-funds rate, pushing it down to 4% from its current range of 5.25%-5.5%.
The “higher for longer” scenario is punishing bonds. The 10-year U.S. Treasury yield has leapt from 3.95% at the end of 2023 to 4.63%. Overall, long-term bonds are down more than 9% in total return for the iShares 20+ Year Treasury Bond exchange-traded fund. On an annualized basis, long-term Treasuries are enduring their worst stretch in 65 years, according to Bank of America.
Still, fixed income experts see the rate climate improving if the Fed manages to push through a cut or two later in the year. Yields are attractive, and if the economy stays healthy, credit metrics should hold up, supporting prices in corporate debt. All that could make for good opportunities within the bond universe, particularly in investment-grade corporate, junk bonds, and floating-rate bank loans. Municipal bonds also are attractive.
“Adding exposure to high-quality bonds is a good idea for investors sitting in cash,” Matthew Palazzolo, senior investment strategist at Bernstein Private Wealth Management. “You can get an attractive level of income and price appreciation.”
Broad market indexes are dominated by Treasuries and agency-backed mortgage securities, essentially making them one-way bets on rates; corporate bonds offer more interest income in return for taking credit risk, with lower-rated debt yielding the most.
Two “core plus” ETFs—which include bonds that aren’t in the major indexes—to consider are iShares Yield Optimized Bond and Fidelity Total Bond. The iShares ETF, aiming for above-average yields, is a fund of funds and includes some riskier elements with 20% in junk bonds and 10% in emerging-markets debt. The Fidelity fund is also a little riskier than conservative core plus funds, according to Morningstar, but provides an “edge in risk-on markets.”
Given the market’s rate risks, some strategists recommend staying at the short end of the yield curve. Yields are slightly higher at the short end, resulting in an “inverted” yield curve, and some strategists see scant gains from venturing out to the long end. “There is a lot more risk on the long end than people realize,” says Doug Fincher, portfolio manager with advisory firm Ionic Capital Management.
Vanguard Short-Term Corporate Bond ETF tracks the market well. It yields 5.2% and has a “duration,” a measure of rate sensitivity, at just 2.8 years. That means it would lose roughly 2.8% if rates were to rise by a percentage point.
Other funds to consider include JPMorgan Limited Duration Bond ETF and Pimco Enhanced Short Maturity Active ETF. The JPMorgan fund yields around 4.7%. The Pimco fund yields 5.3%, using derivatives and futures to help boost returns.
Within corporates, bonds issued by major banks look attractive. “High quality credit is tighter but we’re still finding value in bank bonds,” says Mike Sanders, head of fixed income at Madison Investments.
One benefit of rates staying higher for longer is that it should support lending margins for banks, says Sanders. Bonds he likes now include 5-year issues from megabanks JPMorgan Chase, Bank of America, Wells Fargo, and Citigroup as well as “superregionals” like PNC Financial Services and U.S. Bancorp. Many of them yield above 5%.
With the economy holding up, several strategists see value in corporate issues in junk territory. “Given that we believe in the soft landing scenario, we accept the fact that default risks are lower than historical. So we like higher yield and bank loans,” says Jim Caron, chief investment officer of the portfolio solutions group at Morgan Stanley Investment Management.
To play it safe, stick with bonds rated just below investment grade, avoiding deep junk territory. The VanEck Fallen Angel High Yield Bond ETF focuses on issuers that have lost their investment-grade rating but remain at the upper echelons of junk. It has a solid long-term record, yields 6.7% and is flat this year. Others to consider include mutual funds BlackRock High Yield Bond and Credit Suisse Strategic Income. Both yield above 6.5% and have long-term records that beat the category averages.
One other way to think about junk bonds is as a variant on equities. While they won’t perform as well in a bull market, they should tag along for the ride if the Fed can orchestrate a “soft” or “no-landing” economic scenario after its aggressive rate hikes. “If you are comfortable with where the economy is and a soft landing, then the case for owning below investment-grade bonds is as an equity substitute,” says Gene Tannuzzo, global head of fixed income at Columbia Threadneedle Investments.
One mutual fund playing both angles is Fidelity Capital & Income. It holds about 75% in bonds, mostly rated below investment grade, and keeps 18% in stocks, including tech companies like Meta Platforms, Nvidia, and Microsoft. It yields more than 5% and is ahead about 3.3% this year.
Senior bank loans, often referred to as leveraged loans, are holding up well in this climate. The bonds typically mature every few months, resetting their coupon payments with prevailing short-term rates. Yields are comparable to junk bonds due to loan credit ratings that are generally below investment-grade.
If rates were to fall, coupon rates would decline, though the bonds would rally in price. Conversely, “if rates stay higher for longer, you’ll continue to get a nice yield on these types of instruments,” says Nicholas Brooks, head of economic and investment research at Intermediate Capital Group.
The largest ETFs in the space include iShares Floating Rate Bond ETF, and Invesco Senior Loan ETF. Yields range from 5.8% to 8.3% and the ETFs are up around 2% this year on a total return basis.
Municipal bonds could also rebound. Many muni funds are down at around 2% this year. But credit ratings are generally high—AA-rated or better—local tax revenues are holding up in a strong economy, and there’s a tailwind from infrastructure spending on roads and other projects that should boost tax revenue for states and localities, says Bob DiMella, an executive managing director at MacKay Shields.
“Increased infrastructure spending is going to continue,” he adds.
Yields get more attractive for investors in higher tax brackets since muni income is exempt from federal income taxes. The iShares National Muni Bond ETF, for instance, yields 3.35%, equivalent to a taxable yield of 5.15% for investors in a 35% federal bracket. State-based muni funds may be better for investors in high-tax states like California, New Jersey, or New York. That is because investors don’t have to pay state taxes on muni bonds issued in the state where they live.
Write to Paul R. La Monica at [email protected]
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