Market Insights is a piece in which Kensington’s Portfolio Management team will share interesting and thought-provoking charts that we believe provide insight into markets and the current investment landscape.
US Fixed Income Market 2024
Given the continued explosion of AI this year and its impact on equity markets, both positive (higher index returns) and negative (deteriorating breadth), it’s easy to forget that entering the year, many believed 2024 would be “The Year of the Bond”. Optimism was centered around expectations for Federal Reserve rate cuts, with as many as seven cuts priced into the market at the beginning of the year. However, year-to-date, bond returns have been mixed at best, with most bond categories hovering around flat or slightly negative (chart below).
Source: Bloomberg. Total returns from 12/31/2023 through 6/3/2024 | Charles Schwab
Market Expectations and Fed Rate Cut Guidance
Despite the lackluster start, it may not be too late for bonds to stage a rally in 2024. After a significant adjustment down, the market is now more aligned with Fed rate cut expectations, creating a potential window of opportunity. According to the latest Federal Reserve dot plot, the primary discrepancy between the Fed and the market lies in the neutral rate projection. The Fed estimates it to be around 2.5-3.0%, while the market views it at 3.5-4.0% (chart below). With rate cut expectations now in line, bonds can potentially find their footing and start to gain.
Source: FMRCo. Bloomberg, Haver Analytics, FactSet. Data as of 6/16/2024. Past performance is no guarantee of future results
Reasons For Optimism
In addition to the recalibration of rate cut expectations, several factors suggest potential for a fixed income rally in the second half of the year:
- Attractive Entry Point: Following a prolonged bear market, bond yields are at their highest levels in over 15 years, making it an attractive entry point for investors as strong bond returns typically follow higher starting yields (chart below).
- Economic Resilience: Despite the unemployment rate ticking up to 4% in the latest jobs report, the U.S. posted surprisingly large gains in both jobs (272,000 new jobs) and pay (average hourly earnings up 4.1% y/y) in May, reinforcing the economy’s resilience.
- Improving Duration Profile: The painful duration risk experienced over the past 24 months is now likely less of a concern. With rate hikes seemingly ended and possibly set to drop, duration can potentially become an asset to bond portfolios once again.
Source: PGIM Investments
Reasons for Caution
Despite the optimism, there are several risks to consider:
- Re-inflation: Rate cuts are by no means a certainty. Persistent inflationary pressures could force the Fed to reconsider its rate cut strategy, negatively impacting bond prices.
- Corporate Defaults: We’ve seen a rise in corporate bankruptcies over the last several months (chart below), with 192 companies filing for bankruptcy since March, the highest three-month total since COVID. If that trend continues, it could pose a significant risk for bond investors. Additionally, an economic slowdown might strain corporate earnings, leading to higher default rates.
- Geopolitical Risks: Uncertain global economic conditions, such as China's economic policies or faltering European growth, could introduce volatility.
Data compiled June 5, 2024. Includes S&P Global Market Intelligence-covered US companies that
announced bankruptcy between Jan. 1, 2020, and May 31, 2024.
S&P Global Market Intelligence's bankruptcy coverage is limited to public companies or private companies with public debt where either
assets or liabilities at the time of the bankruptcy filing are greater than or equal to $2 million, or private companies with public debt
where either assets or liabilities at the time of the bankruptcy filing are greater than or equal to $10 million.
Involuntary bankruptcy filings are also included.
Source: S&P Global Market Intelligence. ©2024 S&P Global.
Federal Reserve's Currant Stance and High Yield Bonds
Federal Reserve officials are cautiously optimistic about the economic outlook for 2024. While they do not foresee a recession and expect inflation to trend toward the 2% target, they remain hesitant to lower interest rates until they see sustained progress. This non-committal stance on rate cuts makes high-yield bonds potentially the most appealing category in fixed income. Given their relatively shorter average duration (HYG: 3.32 vs AGG: 6.08 as of 5/31/24) and yield to maturity (HYG: 7.96% vs AGG: 5.10 as of 5/31/24), high-yield bonds may offer an attractive opportunity in the fixed income market even if rates remain unchanged. Of course, it's important to note that high-yield bonds are more sensitive to economic downturns. Therefore, a tactical approach to high-yield bond investing may prove prudent.
Conclusion
While the U.S. fixed income market faces both opportunities and risks, strategic investments in specific bond sectors, could offer attractive returns in the latter half of 2024. Investors should stay informed about Fed policies, inflation trends, and economic indicators to navigate this complex market landscape. The current environment, where rates are high but stable, offers a unique opportunity for bond investors to lock in substantial yields and potential price appreciation.
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