by John Lohse, CFA, Senior Analyst, Research, LPL Research
After a strong third quarter in which the Bloomberg Aggregate Bond Index posted a 5.2% gain, bonds finished September with a 4.5% year-to-date return. Following the Federal Reserve’s (Fed) September Federal Open Market Committee (FOMC) meeting in which it delivered a 0.5% interest rate cut we saw rates of shorter maturity bonds follow suit and trade lower. In the days following, intermediate/long dated bonds, as measured by 10-year U.S. Treasuries (UST), saw their rates bounce off mid-month lows of 3.62% and finish September at 3.8%. Since then, those yields have crept higher and are currently above 4.0%. These levels fall right in line with our year-end target for the 10-year UST of 3.75%-4.25%. So, what do seemingly rangebound benchmark rates amidst Fed rate cuts mean for bonds, and what should capital allocators do going forward?
The Bond Landscape
With nearly 2% more in rate cuts expected, the market is currently pricing in a soft landing. Under these conditions intermediate and long rates tend to drift higher as we experienced in the second half of September. As such, barring a deterioration in economic conditions we expect our rangebound target for the 10-year of 3.75%-4.25% to hold. A neutral tactical asset allocation to bonds, down from our recent overweight versus the benchmark, seems prudent here due to limited expected price appreciation, however coupon rates are still attractive. Among the neutral tactical allocation to bonds, given a slowing economy and heightened geopolitical risks, a neutral position to interest rate (duration) sensitivity makes sense here as well. Shorter-term bonds by their nature are shorter lived, and as those bonds come to maturity the risk of re-investing proceeds at a lower rate outweighs the potential for price appreciation from falling rates along those shorter maturity key rates.
High-Yield Bonds
Outside of core bonds, lower quality fixed income continues to trade at historically low spreads. Said differently, the incremental interest rate those bonds bear for being of lower quality is historically small, which is a poor value proposition for investors, in our view. Tighter spreads also raise the potential for negative price skew as the compression can only go so low. The possible price return dispersion from here tilts asymmetrically to the downside. The continued, albeit slowing, economic growth and anticipated avoidance of recession remains supportive of low-quality debt, however we believe the risk/reward tradeoff is unattractive at these levels.
The chart below highlights the historical percentile rank of the option adjusted spreads on BB and B rated corporate bonds during the last 20 years. Spreads are near two-decade lows, trading at the 2nd and 7th percentiles, respectively, meaning spreads have been higher 98% and 93% of the time, respectively.
Historically Tight Credit Spreads
Source: LPL Research, Bloomberg 10/08/24
Disclosures: Past performance is no guarantee of future results. All indexes are unmanaged and can’t be invested in directly.
Preferred Securities
While high-yield bonds don’t appear to offer compelling all-in yields right now, we believe there’s still value in preferred securities. From the beginning of April 2023 through September 2024 the BofA US All Capital Securities Index has returned over 20%, cumulatively, beating the Bloomberg Aggregate Index by over 13%. We’ve held a strong overweight position in preferreds for those past 18 months and now favor slightly paring that position back to reap the solid returns over that time. The healthy price appreciation has tempered enthusiasm somewhat; however, we still favor the asset class (just at a reduced weighting) as it is generally higher quality compared to riskier fixed income options, possesses good issuer fundamentals, and has a constructive technical backdrop.
Conclusion
While some things like projected future interest rates have changed, other areas of the bond market such as credit spreads have remained entrenched. LPL Research believes a step back into a neutral tactical asset allocation bond positioning can help lock in gains on strong performing sectors, wait out a rangebound rate environment and weather potential economic and geopolitical headwinds. For those looking to tactically deploy proceeds from such a move we view alternative investments as an attractive choice. In particular, Global Macro alternatives can provide robust diversifying effects and Multi-Strategy alternatives can offer advantageous, dynamic, uncorrelated investing. The Fed has enacted the catalyst for change in the fixed income landscape, and the market has begun to sketch its roadmap.
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