Fixed Income: Down but Not Out

Laurence Gillum:

It's been another slow start to the year for fixed income investors with the core bond index, which is the Bloomberg Aggregate Bond Index, down around 1% this year. A strong economy and still stubbornly high, but falling inflationary pressures have pushed out to prospects of Fed rate cuts, which has pushed up Treasury yields as well and caused negative bond returns. But in this edition of the LPL Street View, we explain why we think fixed income may be down but not out. It seems like we just can't stop talking about the Federal Reserve. After an aggressive rate-hiking campaign that ended last year, markets were expecting the Fed to start cutting interest rates as early as this month. But with an economy that continues to surprise the upside, along with inflationary pressures that are still above the Fed's 2% target, it looks like it will still be a few months before we get those rate cuts.

Laurence Gillum:

To be clear, we think it's a matter of when rate cuts happen, not if. We still expect rate cuts this year, but in the meantime, it has meant higher bond yields, lower bond prices, and higher interest rate volatility. But one of the great things about fixed income, and there are a lot of great things about fixed income, but for fixed income investors that can hold bonds to maturity, interest rate volatility doesn't really matter. Remember, bonds are financial obligations that are contractually obligated to pay periodic coupons and return principal at or near par at the maturity of the bond. That is, absent defaults, there's a certainty with bonds that you don't get from many other financial instruments. So when you buy an individual bond, you effectively lock in the current yield. And right now there are a number of still very attractive opportunities within this market.

Laurence Gillum:

There are three primary reasons to own fixed income: diversification, liquidity, and income. And with the increase in yields, recently, fixed income is providing income. Again. Right now, investors can build a high-quality fixed income portfolio of U.S. Treasury securities, AAA-rated agency, mortgage-backed securities, and short-to intermediate-maturity investment-grade corporate bonds that can generate attractive income. Investors don't have to "reach for yield" anymore by taking on a lot of risk to meet their income needs. And for those investors concerned about still higher yields, laddered portfolios and individual bonds held to maturity are great ways to take advantage of these higher yields. The market likely got ahead of itself late last year in pricing and aggressive rate cuts, so the backup in Treasury yields we've seen to start the year is warranted in our view. However, starting yields from many fixed income markets are still at levels last seen over a decade ago.

Laurence Gillum:

So the return prospects for fixed income remain favorable as well. And while we do not expect the Fed to cut rates at their meeting later this month, we still expect cuts this year, which should mean bond yields are likely going lower. And investors under-invested in fixed income and perhaps over-invested in cash will likely miss the current opportunity. Over the past decade, interest rates were at very low levels by historical standards. Now, the sell-off over the past few years has taken us back to more normal interest rate levels. And while the transition out of the low interest rate environment to this more normal range has been a challenging one for fixed income investors, we think the current setup is a positive one. It's not to say there won't be volatility. There will be, but we think the risk/reward for fixed income is as attractive as it's been in some time and think fixed income is still a very important part of a diversified asset allocation. Thanks for listening.