Can the bond rally continue?

Probably not at this year's rapid pace. But there should be pockets of opportunity.

by Chris Pariseault, CFA, Head of Fixed Income and Global Asset Allocation Institutional Portfolio Managers, Fidelity Investments

Key takeaways

• The Federal Reserve is likely to further lower interest rates this year.
• Lower rates have helped push up prices for many types of bonds in 2019, including highly rated "investment grade" corporate bonds.
• But bond prices may not continue their strong gains in 2020.
• Opportunities may exist in lower-quality investment grade and high yield corporates and Treasury Inflation-Protected Securities (TIPS), but you need to do your homework.

A spike in stock market volatility is one of the reasons why investors are turning toward bonds. While stocks have been rising and falling this year, the bond market is on pace to deliver its highest returns in more than a decade. Between January and September, the Barclays Capital US Aggregate Bond Index¹—which represents the overall investment grade bond market—returned 9%. During that same time, highly rated investment grade corporate bonds, which are issued by many of the same big companies that stock investors recognize from the S&P 500² have gained 14%, their best performance in nearly a decade.

But all good things eventually come to an end. As market conditions change, can return-seeking investors still expect the same bang for their buck from bonds?

Viewpoints spoke with Chris Pariseault, CFA, Fidelity's Head of Fixed Income and Global Asset Allocation Institutional Portfolio Managers, about what may lie ahead for rates and bonds, especially for high-flying investment grade corporates.

When investors talk about bonds, the big question is always "Will the Fed cut rates again?"

I think so. The Federal Open Market Committee (FOMC)—the group at the Federal Reserve that sets monetary policy—noted at its July meeting that it was ready to ease interest rates. It followed through in September with a 25-basis-point cut. In their July minutes, the FOMC offered 3 reasons for rate cuts: to offset any slowdown in economic growth, to address rising market volatility due to international trade conflicts, and to provide insurance against various risks. I have seen these risks continue to materialize.

What is the Fed trying to accomplish by cutting rates?

The Fed's mission is to increase economic growth and to manage inflation. The Fed has been managing market expectations to make sure that its policies support that mission, and that means lowering interest rates to support the stock and corporate bond markets.

The stock market is pricing in one more rate cut this year, but that will depend on economic data. After the most recent 25-basis-point cut, I expect that the Fed will cut rates by another 25 basis points before the end of the year. The data will tell the story but the inverted yield curve between the 3-month Treasury bill and the 5-year Treasury note is signaling that the market thinks the Fed is not accommodative enough. Weak data will further pressure rates downward in my view.

What do lower rates mean for bond investors?

Lower yields have led to higher bond prices, which has meant that investors who were in bonds since the beginning of the year have enjoyed strong returns. We have seen the yield on 10-year US Treasury bills fall by about 100 basis points (1%) while the 30-year US Treasury bond has rallied by about 90 basis points (0.9%). We are now at more modest yield levels and this means that investors will need to temper their expectations for future returns given the lower yield environment. We saw a similar scenario in 2016 after the 10-year US Treasury reached its prior low of 1.35%. The 10-year US Treasury currently stands at 1.62%.

Why do you think lower rates might not translate into higher bond prices and greater returns for investors?

For starters, bond prices have already risen sharply this year. Bond prices and bond yields move in opposite directions. The yield on the Barclays Aggregate index began the year at 3.28% and fell to 2.15% by the end of August. As yields fall, bond prices rise: 10-year Treasuries have returned 13% year to date, and the Barclays Aggregate is up 9%. Long US Treasury bonds (20+ years) have returned a staggering 20.2% year-to-date. We haven’t seen these types of returns since 2009, the year that many sectors began to recover from the global financial crisis.

Investment grade bonds issued by US corporations have been among the best performers this year. Should investors temper their expectations about the future of these bonds too?

The rally in investment grade credit has pushed up prices on US corporate bonds. This year through September, investment grade corporate's year-to-date excess return—its return advantage over Treasury securities—was 375 basis points. That was the fifth-best excess return in the last 30 years. So while I feel very comfortable with the US economy and with the US bond market, relatively high valuations are keeping me from getting overly excited about investment grade corporates. I'm mostly neutral on it.

That said, we do see appeal in the bonds issued by companies in the financial sector, especially big banks, as well as bonds issued by certain companies with credit ratings of BBB that represent the lower end of the spectrum of investment grade bonds, which ranges from AAA to BBB.

What's appealing about BBB-rated bonds?

The market has priced a lot of risk into BBB-rated bonds. In an economic downturn, lower rated investment grade bonds have a greater likelihood of default and therefore are likely to underperform the broader bond market. For some issuers with high levels of debt that is certainly a risk.

Unlike in the past, though, the BBB market today is made up of bonds from a lot of high-quality companies such as AT&T, Verizon, and Anheuser Busch InBev that took advantage of historically cheap interest rates to borrow money which they used to refinance debt and issue share buybacks, among other purposes. That borrowing left them with higher levels of debt that pushed some companies’ credit ratings down a notch or two into the BBB-rated category. However, it also gave them much needed flexibility to restructure and we think that some of these issuers are now candidates to have their ratings raised.

So how would you suggest that investors position their bond portfolios in this environment?

A bond portfolio should reflect your long-term strategic goals. While yields are low today, I continue to advocate for a well-diversified portfolio that is made up of broad sector exposures commensurate with the appropriate risk and return objectives. Treasury Inflation-Protected Securities (TIPS), are about fair value given current inflation expectations, but their prices could rise if inflation goes up unexpectedly”. Lower-rated investment grade corporate bonds offer decent yield but again they have performed well. So diversified exposure within that segment of the market makes sense. I have also found high yield bonds attractive given the low default rate environment. However, this sector tends to exhibit higher volatility during times of stress as we saw in late 2018.

Finding corporate bond ideas

Fidelity's mutual fund and ETF screeners can help you find corporate bond investment ideas. Below you can find a list of funds and ETFs that invest in investment grade corporates. (Note: These results are illustrative and are not recommendations by Fidelity or the fund managers.) For additional ideas on bonds, bond funds and bond ETFs, including high yield and TIPs, check out our bond research hub.