What Fixed Income Investors Can Look Forward to in 2024

Lawrence Gillum (00:00):

With Thanksgiving behind us and the holiday season fast approaching, we want to offer up some potential good tidings that fixed income investors can look forward to in the new year. So before we bid 2023 adieu in this edition of the LPL Street view, we give some reasons why this year may mark the end of the bond bear market and why 2024 could be a good year for fixed income investors. There's no doubt the last few years have been challenging for fixed income investors, and while 2023 was supposed to be the year for bonds, fixed income returns for most core bond categories have only recently turned positive for the year. That said, despite the recent challenges, we think there are several reasons to be optimistic as we head into the new year about the current set-up within fixed income. As such, here are four things we're optimistic about within the fixed income markets for 2024.

Lawrence Gillum (00:52):

Number one, the end of the federal reserve rate hiking campaign. The biggest headwind of the fixed income markets over the last few years has unequivocally been the Fed. Over the last 20 months, the Fed increased its fed funds rate by over 5%, including 4.75% rate hikes over the course of four Fed meetings. However, with inflationary pressures abating, although admittedly still too high to warrant rate cuts, we think the Fed is likely done, which should eliminate the biggest headwind to fixed income markets. In fact, at the Fed meeting next week, not only do we not expect a rate hike, we also think they will justify a number of rate cuts that are currently priced into the market. Now, core bonds tend to do well at the end of these rate hiking campaigns. Since 1984, core bonds as proxied by the Bloomberg Aggregate Bond Index were able to generate average six month and one year returns of 8% and 13% respectively after the Fed stopped raising rates.

Lawrence Gillum (01:54):

Moreover, all periods generated positive returns over the six month, one-year and three year horizons. And number two, the favorable risk return profile for core bonds, well, not unique to fixed income per se. The asset class has a feature that makes negative price performance increasingly difficult to continue due to rising rates alone. Fixed income returns are a combination of price, performance, and income. So as yields rise, the income component increases as well. The higher income component serves as a hurdle rate or a yield cushion that will need to be eclipsed before further losses are realized. As such, these higher hurdle rates may decrease the probability of losses due to an increase in interest rates. Yields in many cases would need to increase by 1% or more to offset current levels of income, which we think is unlikely given our expectations that the Fed is done with its rate hiking campaign.

Lawrence Gillum (02:51):

Number three, the potential for equity-like returns without equity-like risks. While our base case is for the 10-year treasury yield to trade between 4.25% and 4.75% this year, and generally lower next year, given starting yields, it would not take much of a sustained drop in yields to generate high single digit low double digit returns over a 12-month horizon. For a number of these high quality fixed income sectors. For example, a 0.5% drop in yields could likely generate close to a 10% return over 12 months for AAA rated agency mortgage-backed securities. Furthermore, if the economy slows and the Fed cuts rates more than we expect next year, these high quality fixed income sectors could generate 12 to 13% type returns, no guarantees of course. And number four, the ability for income oriented investors to generate income. Again, there are three primary reasons to own fixed income, diversification, liquidity, and income.

Lawrence Gillum (03:51):

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, true 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 ways to take advantage of these higher yields. Over the past decade, interest rates were at very low levels by historical standards. Now, the selloff over the past few years has taken us back to more normal interest rate, 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. That'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 look for better returns in 2024. Thanks for listening. I hope everyone enjoys their holiday season.