Four reasons why investors should pay attention to bonds
The bond market turmoil that started in October marked one of the worst sell-offs in history, but as 2023 draws to a close, one market veteran says there’s reason for optimism about interest income heading into the new year. He believes that investors should pay attention to bonds.
In a late November note, Lawrence Gillum, chief interest rate strategist for LPL Financial, pointed out that bonds have only recently turned positive for the year.
He listed five reasons why the current setup bodes well for investors, starting with the end of the Federal Reserve’s rate hike campaign.
“The biggest headwind to fixed income markets over the past few years has unequivocally been the Fed” said Gillum. With disinflation continuing at a steady clip, he said the central bank is likely done with its monetary policy tightening. [We think the Fed is likely done, which should eliminate the biggest headwind to interest rate markets,” he said.
Second, Gillum pointed to the asymmetric risk-return profile of bonds, largely due to the higher “yield cushion” that can offset higher interest rates.
Third, the strategist said that bond investors could see stock-like returns – without stock-like risks.
LPL Financial has a base case for the 10-year Treasury to hover at 4.25%-4.75%, but it argues that a sustained decline in interest rates could lead to high single-digit or low double-digit returns over the next 12 months for fixed-rate income investments.
“[I]f the economy slows and the Fed cuts rates more than we expect next year, these high quality fixed income sectors could generate 12-13% returns (no guarantees of course),” Gillum wrote in the note.
And fourth, the current interest rate landscape will open the door for income-oriented investors to generate income again, in his view. Right now, he said, bond investors can build a high-quality portfolio of U.S. Treasuries, AAA-rated mortgage-backed securities and short-maturity investment-grade companies.
“Investors no longer need to ‘pursue returns’ by taking large risks to meet their income needs,” Gillum said. “And for those investors concerned about even higher returns, portfolios of ladders and individual bonds held to maturity are ways to take advantage of these higher yields.”
Gillum writes that as markets transition to a more normal interest rate environment, bond investors are in a good place as 2023 ends.
“That’s not to say there won’t be volatility, there will be, but we think the risk/reward of fixed income is as attractive as it has been for a long time, which we are grateful for.”
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