Proceed With Caution in the Bond Market
Long-term interest rates have traded sideways recently, but LPL Research argues that high-quality bonds can play a pivotal role in mitigating equity risk.
We think high-quality bonds—despite higher interest rates—can play a pivotal role in portfolios as they remain the best diversifier to equity risk. Unforeseen events happen and it’s best to have that potential portfolio protection in place before it’s needed.
After one of the worst starts to a year for fixed income, returns may not get much better from here. Long-term interest rates have traded sideways recently but we expect rates to potentially rise further, which would put downward pressure on bond prices. We’re not giving up on high-quality fixed income though, as Treasury securities have shown to be the best diversifier during times of equity market stresses.
The Case for (still) Higher Treasury Yields
Interest rates have moved off their very low levels to start the year, but we think they can go higher. Higher inflation expectations, less involvement in the bond market by the Federal Reserve (more on this below), and a record amount of Treasury issuance this year are all reasons why we believe interest rates can move higher. We think the 10-year Treasury yield could end the year between 1.75% and 2.0%.
Inflationary pressures are building as the economy continues to recover. As one of bondholders’ main nemeses, inflation, erodes the “real” value of principal and interest payments, making them worth less. While we don’t believe inflation will be a lasting problem, we do expect higher consumer prices in the near term, which should nudge interest rates higher over the rest of this year. Moreover—and why we believe copper is an important commodity to watch, as seen in [Figure 1]—the ratio of copper prices to gold prices has been an important predictor of where the yield of the 10-year Treasury should be. Copper is an important input price for a number of products so, while copper prices have increased due to the strengthening of the global economy, 10-year Treasury yields haven’t kept up. While not a perfect predictor, the copper/gold ratio has been a fairly reliable one—and one that suggests interest rates can move higher than current levels.
Rising Treasury yields have been a headwind to core fixed income returns this year. Generally speaking, the yield spread between Treasury securities and non-Treasury bond securities can help cushion losses when interest rates move higher (and bond prices fall). However, with valuations within most fixed income sectors already at lofty levels, there hasn’t been enough spread to offset rising Treasury yields. This has caused the prices of many bond sectors to fall as interest rates have moved higher. Unfortunately, we expect the trend of higher interest rates to continue, albeit at a much slower pace than what we’ve already experienced so far this year, putting further downward pressure on core fixed income returns. As seen in [Figure 2], expected returns for core fixed income (as defined by the Bloomberg Barclays U.S. Aggregate Bond Index) through the remainder of the year are low to even negative in certain scenarios. Because we believe interest rates will move higher from current levels, core fixed income returns may add more negative returns to the already negative year-to-date returns. If core fixed income returns are negative for the year, it will be the first time since 2013, which was the last time the Federal Reserve (Fed) started talking about tapering its bond buying programs. History may be rhyming again.
Portfolio Protection During Market Sell-Offs
So, if we’re expecting higher Treasury yields and low-to-negative returns for core fixed income, why would anyone want to own bonds? Frankly, in case something bad happens to cause equity markets to sell off. Core bonds, and more specifically Treasury securities, have shown to be the best diversifier to equity market declines. [Figure 3] shows the monthly returns of the Treasury index during months when the S&P 500 Index was down 3% or more during the month. When we look at how Treasury securities have performed during periods of equity market selloffs, we can see that Treasury security returns have been mostly positive. When you consider stocks are in the second year of a bull market which, historically, has brought increased volatility, core fixed income can help dampen and potentially offset some of those losses. While we still like equities over bonds over the course of the year, we do think high-quality fixed income continues to serve a purpose in portfolios.
All Eyes on the Federal Reserve
When we evaluate the economic and financial landscapes, the Fed is a key risk we’re keeping our eyes on. Since March 2020, the Fed has supported the economy and financial markets by purchasing $120 billion in Treasury and mortgage securities, and by keeping short-term interest rates near zero. As the economy continues to recover, however, the need for continued monetary support wanes. While we still think it’s too early for the Fed to begin to increase short-term interest rates, we do think the discussion around reducing the size and scope of bond purchases will start to take place soon. How the market will react to these discussions is unclear at this point, and the policy risk associated with a possible communication error by the Fed is a risk that could cause interest rates to move higher.
Core fixed income returns have—not unexpectedly—been negative so far this year. With long-term interest rates near historical lows coming into the year and the economy on the mend, we thought interest rates would move higher this year—and they have. We think long-term interest rates still have room to move higher even after the big move this year, so bonds may experience subpar returns throughout the rest of the year. We still think high-quality bonds play a pivotal role in portfolios as a diversifier to equity risk. While we expect further gains for stocks through year-end, unforeseen events happen. And it’s best to have that potential portfolio protection in place before it’s needed.
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