Is now the time to buy bond funds?
Short-term bond yields are high currently, but with the Federal Reserve poised to cut interest rates investors may want to consider longer-term bonds or bond funds. High-quality bond investments remain attractive.
Yields on the benchmark 10-year U.S. Treasury moved higher at the start of 2024 but are mostly holding between 4.20% and 4.30% now, well below earlier peaks of nearly 5%. Bonds in the current environment appear to offer investors more attractive long-term opportunities.
Vanguard's active fixed income team believes emerging markets (EM) bonds could outperform much of the rest of the fixed income market in 2024 because of the likelihood of declining global interest rates, the current yield premium over U.S. investment-grade bonds, and a longer duration profile than U.S. high yield.
Key Takeaways. Most bonds pay a fixed interest rate that becomes more attractive if interest rates fall, driving up demand and the price of the bond. Conversely, if interest rates rise, investors will no longer prefer the lower fixed interest rate paid by a bond, resulting in a decline in its price.
In a recession, investors often turn to bonds, particularly government bonds, as safer investments. The shift from stocks to bonds can increase bond prices, reduce portfolio volatility, and provide a predictable income. However, drawbacks include lower yield potential, default risks, and interest rate risks.
The valuations of small-capitalization stocks in particular seem to already price in a recession. As for fixed income, we expect a strong bounce-back year to play out over the course of 2024. When bond yields are high, the income earned is often enough to offset most price fluctuations.
In the short run, rising interest rates may negatively affect the value of a bond portfolio. However, over the long run, rising interest rates can actually increase a bond portfolio's overall return. This is because money from maturing bonds can be reinvested into new bonds with higher yields.
5. Strong demand should support bonds in 2024. I believe investors are going to shift an increasing amount of money to fixed income and more interest rate-sensitive assets in 2024 as the Fed has signaled an end to its hiking cycle.
Although some volatility may continue, we believe interest rates have peaked. We expect lower Treasury yields and positive returns for investors in 2024.
When interest rates rise, existing bonds paying lower interest rates become less attractive, causing their price to drop below their initial par value in the secondary market. (The coupon payments remain unaffected.)
Is it better to buy bonds when inflation is high?
Impact of Inflation on Fixed Income Investments
Bond prices are inversely rated to interest rates. Inflation causes interest rates to rise, leading to a decrease in value of existing bonds. During times of high inflation, bonds yielding fixed interest rates tend to be less attractive.
Face Value | Purchase Amount | 30-Year Value (Purchased May 1990) |
---|---|---|
$50 Bond | $100 | $207.36 |
$100 Bond | $200 | $414.72 |
$500 Bond | $400 | $1,036.80 |
$1,000 Bond | $800 | $2,073.60 |
Bond prices and interest rates move in opposite directions, so when interest rates fall, the value of fixed income investments rises, and when interest rates go up, bond prices fall in value.
Cash and Cash Equivalents
Cash equivalents include short-term, highly liquid assets with minimal risk, such as Treasury bills, money market funds and certificates of deposit. Money market funds and high-yield savings are also places to salt away cash in a downturn.
Some of the worst investments during high inflation are retail, technology, and durable goods because spending in these areas tends to drop.
Cash, large-cap stocks and gold can be good investments during a recession. Stocks that tend to fluctuate with the economy and cryptocurrencies can be unstable during a recession.
In December, many investors welcomed the Federal Open Market Committee's unanimous decision to hold rates between 5.25% and 5.5% and signal some rate cuts in 2024. The Federal Reserve's so-called dot plot in December suggested a median fed funds rate of 4.6% in 2024, followed by 3.6% in 2025 and 2.9% in 2026.
- Vanguard Total Bond Market ETF (BND)
- Vanguard Core-Plus Bond ETF (VPLS)
- iShares MBS ETF (MBB)
- Invesco Ultra Short Duration ETF (GSY)
- SPDR Bloomberg 1-3 Month T-Bill ETF (BIL)
- iShares Aaa – A Rated Corporate Bond ETF (QLTA)
- Schwab Short-Term U.S. Treasury ETF (SCHO)
- Schwab Intermediate-Term U.S. Treasury ETF (SCHR)
Traditionally, the answer has been that bonds provide diversification and income. They zig when stocks zag, providing income for spending needs. In finance terms, bonds have “low correlation” levels to stocks, and adding them to a portfolio would help to reduce the overall portfolio risk.
2 When the market consensus is that a rate increase is right around the corner, it's time to go to market. Unless you are set on holding your bonds until maturity despite the upcoming availability of more lucrative options, a looming interest rate hike should be a clear sell signal.
Will my bond funds ever recover?
The table on the right shows that bond prices often recover within 8 to 12 months. Unnerved investors that are selling their bond funds risk missing out when bond returns recover. It is important to acknowledge that some of those strong recoveries were helped by bond yields that were higher than they are today.
The key benefits to owning bond funds are: Greater diversification per dollar invested: It is much easier to achieve a diversified bond portfolio per dollar invested using a fund, because you obtain exposure to a basket of bonds within the fund.
The March 2024 12-month I Bond rate of 5.27% is similar to CDs and Treasury Bills that are roughly 5% interest over the same time frame. Also consider the 3-month recent interest penalty if you cash out in the first 5 years.
The S&P 500 generated an impressive 26.29% total return in 2023, rebounding from an 18.11% setback in 2022. Heading into 2024, investors are optimistic the same macroeconomic tailwinds that fueled the stock market's 2023 rally will propel the S&P 500 to new all-time highs in 2024.
U.S. stock returns: 2023 optimism carries forward
This heightened optimism is on par with the positive outlook in December 2021, when investors anticipated a 6% stock market return for 2022. Investor expectations for stock returns over the long run (defined as the next 10 years) rose slightly to 7.2%.
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