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Kathy Jones of Schwab

Portfolio > Economy & Markets > Fixed Income

Bond Market Mess Is a Chance to Lock In Higher Yields for Longer

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What You Need to Know

  • Bond investors face a tricky path in the current environment, and volatility in bond prices is expected to persist over the short to medium term.
  • Investors have a chance to lock in rates of 5% or higher on high-quality intermediate term bonds, Schwab's Kathy Jones says.
  • The Fed's projections point to lower rates in 2024 and 2025, Jones says.

With the U.S., the U.K., Norway, South Africa, Switzerland and Sweden all raising interest rates in the last week, the global markets have now seen more than 300 individual rate hikes in little more than a year.

In bond market commentary shared with ThinkAdvisor, Hal Cook, a senior investment analyst with Hargreaves Lansdown, points out that these rate rises have caused significant capital falls in the value of bonds so far in 2022. In turn, bond investors have witnessed the first meaningful rise in yields seen for many years, with 10-year government bonds in the U.S. climbing past 1.5% at the beginning of the year to now stand near 4%.

Cook says the consensus now is that rates will peak at 4.6% next year, based on the Federal Reserve dot plots. This is pushing bond fund managers to be cautious while they seek to position their funds for longer-term return generation.

“This is a tricky path to walk in the current environment and volatility in bond prices is expected over the short to medium-term,” Cook says.

What’s an Investor to Do?

Asked to put this outlook in context for financial advisors and their clients, Kathy Jones, chief fixed income strategist at the Schwab Center for Financial research, says the current environment presents a lot of challenges, but also a lot of opportunities.

“The inverted yield curve has historically been a signal of recession in the next 12 months or so,” Jones says. “Often, investors don’t see a reason to extend duration into intermediate or long-term bonds when short-term yields are so high.”

The problem with that strategy, Jones says, is that the market is signaling that yields will most likely fall over the next year or two. As such, if the Fed continues on its aggressive rate-hiking path, long-term yields will likely lag short-term rates by a larger margin, due to the prospects for weak growth and falling inflation in the longer term.

“Our view is that it makes sense for clients who have been holding money in cash or short duration bonds to start taking on more duration as rates rise,” Jones says. “Although yields are lower on intermediate- to long-term bonds than cash, locking in those yields today is an opportunity.”

In the current environment, Jones says, an investor can get 5% yields or higher in a high-quality intermediate duration portfolio of Treasurys and corporate bonds. It has been a long time since that was possible, and with the risk of recession rising, those yields may not be available next year.

“Staying too short means riding the yield up and down but missing the chance to lock in a higher income stream for longer,” Jones warns. “Even though bond ladders tend to do well over the long run, it is challenging when the yield curve is inverted.”

Of course, a ladder approach still means averaging into the market over time, without trying to predict where interest rates are going. As Jones points out, if the yield curve continues to invert, with short-term rates rising, the lower rungs of the ladder can provide added income. If the yield curve normalizes, with short-term rates falling as anticipated in 2023, then today’s yields are going to look attractive.

“I would point out that the yield curve is upward sloping in the municipal bond market, so that makes the proposition of locking in current yields more attractive than in Treasurys,” Jones says.

Retirement Investing

From her point of view, for those near or in retirement, this is a good time to take some duration risk to provide an income stream from high-quality bonds with some certainty. It may also be a good time to harvest tax losses in lower yielding bonds and reinvest, if that makes sense for the individual investors’ situation.

“Overall, however, for those using fixed income for capital preservation and to generate income, we see the current environment as positive,” she concludes.

‘Sharper, Shorter Cycle’

Looking forward, Jones says, it is “notable” that the Fed’s projection still shows the expectation that short-term rates will drop modestly in 2024 and further in 2025. It’s not the “hike and hold for a long-time” scenario many were expecting, Jones says.

“This is indicating a sharper, shorter cycle with short-term rates falling back toward 2.5% over the long run,” she notes. “Of course, these are just projections as of today, and there is a wide dispersion of views at the Fed. Nonetheless, it appears that the majority at the Fed see rates falling in 2024.”


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