Could Things Start Looking Up for the Bond Market?

In this edition of the LPL Street View, Fixed Income Strategist Lawrence Gillum explains why a transition to a slower rate hiking pace could be good news for the bond market.

The Federal Reserve (Fed) is set to meet again next week, and it is widely expected they will raise short-term interest rates another 75 basis points or three quarters of a percent, to take the fed funds rate up to 4%. The 75 basis point rate hike will be the fourth in a row and only the fifth one since the 1980s. The fed funds rate was close to zero to start the year, so to say the Fed’s current rate hike campaign is an aggressive one is an understatement. The Fed is hiking short-term interest rates at a pace and magnitude unlike any rate hiking campaign since the 1970s. While we think the Fed still has work to do to arrest these stubbornly high consumer price increases, we do think the Fed will take a slower, more cautious approach, to interest rate hikes at subsequent Fed meetings, which could help alleviate a lot of the stresses we’ve already seen in the bond market this year.

Because of the aggressive rate hiking campaign by the Fed, the core bond index (as defined by the Bloomberg Aggregate Bond index) is seeing losses unlike any year since inception of the index. Core bonds are down over 16% this year, and this year’s losses have wiped out five years of gains for the index. But because bonds are both financial instruments and financial obligations that pay coupons and principal repayments at par when they mature, the potential for recovery is a bit more certain than in the equity markets that rely primarily on price appreciation. So how long will it take to recover this year’s losses?

The table shown provides some expectations for various fixed income markets under different interest rate scenarios. So if interest rates don’t change at all, probably an unrealistic assumption, the best expectation for performance over the next year would be the index’s starting yield. However, if interest rates decline by 0.5%, the Bloomberg Aggregate Bond index, for example, could return over 9% over the next 12 months. However, if interest rates move back into the low 3’s, the core bond index could return around 12% over the next year. Importantly, if interest rates increase by another 1% from current levels, fixed income markets broadly could all still generate positive returns. All hypothetical returns of course, but given the move higher in yields that we have already experienced this year, we think the risk/reward for owning core bonds has improved.

While it may be tempting to hide out in cash or other short-term financial instruments, we think the potential for price appreciation within core fixed income could help offset the earlier losses faster than collecting income alone. And we don’t need to see a big decline in interest rates to get there either. That’s one of the great things about bonds and the bond math. Starting yields provide a head start for potential returns.

There is no doubt that this year has been a challenging year for fixed income investors, but we do think the worst is behind us. It will take patience to fully recover this year’s losses, but we think the best way to do that is to stay invested lest you may miss out on the recovery in the fixed income markets that will eventually occur.

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