Thought Leadership in Action

Following a rebound in bond returns in 2023, with yields on 10-year Treasurys briefly hitting the 5% mark, the focus now shifts to the Federal Reserve's potential for interest-rate cuts in 2024. The historical performance of intermediate bonds after rate-hike cycles suggests optimism for bonds as an attractive asset class.

Over the next decade, Vanguard expects U.S. bonds treturn a nominal annualized 4.8.8% to 5.8%,, a significant improvement over Vanguard’s previously projected median range of 1.5 to 2.5%. Financial advisors can talk with clients about the potential for stable income generation and capital preservation with bonds. Here are a few ideas for thinking through bonds in terms of expectations and opportunities.

Why Balance Government and Corporate Bonds?

Financial advisors must consider the consequences of declining company fundamentals on corporate bonds, regardless of whether those bonds are investment grade or high yield. Financial distress or bankruptcy can significantly alter expected bond income. Fundamentals to watch include declining revenue and earnings growth, higher leverage ratios (within historical norms), and lower interest coverage, which may signal potential repayment difficulties.

The Treasury Department is expected to borrow more than $800 billion in the first quarter of 2024. This increased Treasury bond supply could exceed investor demand and put downward pressure on bond prices. If interest rates remain high well into 2024, meanwhile, the government may need to refinance at steeper rates, leading to higher yields.

Advisors should pay close attention to credit spreads between corporate and government bonds. Narrow spreads indicate the reduced appeal of corporate bonds compared with Treasurys.

Make sure you’re explaining the risks and rewards to clients. Go beyond the surface-level appeal of high yields and delve into the potential for a default cycle. Credit spreads alone may not fully capture the underlying risks, making it essential for advisors to carefully evaluate issuer creditworthiness and the potential impact on bond investments.

The Case for Emerging Markets Bonds

In 2023, emerging market (EM) bonds delivered strong performance, driven by a supportive demand and supply dynamic, as well as attractive valuations. EM investment-grade issuers outperformed their fiscal budgets, reducing the need for debt issuance, while high-yield issuers turned to official creditors for funding because of elevated funding costs.

These bonds could outperform other fixed-income assets because valuations remain attractive relative to U.S. investment-grade and high-yield bonds and as central banks look to reduce interest rates, among other reasons.

To capitalize on this opportunity, financial advisors should consider allocating to EM bonds, as they are often underrepresented in portfolios. Educate clients about the potential benefits of EM bonds, such as wider spreads and longer duration than U.S. investment-grade and high-yield bonds. Highlight the potential for rate rallies and increased investor demand.

EM bonds are influenced by geopolitical developments and financial trends such as political stability, regulatory changes and economic growth prospects. Diversifying across EM bonds can mitigate the impact of individual credit quality, country-specific risks, and macroeconomic factors that may affect performance.

The Outlook for Investment-Grade Corporate and Government Credit

With the Federal Reserve pausing rate hikes and signaling cuts ahead, financial advisors should consider extending duration in investment-grade corporate and government credit. Historically, these assets have outperformed Treasurys after rate-hike cycles.

Active management allows advisors to tailor their investing strategy to the distinct environments of different companies and countries. Assessing the health of balance sheets and selecting high-quality assets becomes crucial in this context.

Moving out of cash and short-term assets is recommended, given the favorable environment for intermediate-term investment-grade corporate and government credit. Emphasize high-quality products, such as a mix of Treasurys, investment-grade bonds, and structured products, that give clients exposure to high-quality assets that offer real yield.

As financial advisors navigate the potential comeback of bonds, they must engage with clients about the potential risks and how to mitigate them. Clients who prioritize capital preservation and income generation, such as retirees or investors with a lower risk tolerance, may find a bond-heavy approach appealing. Advisors should explore each client's individual financial goals, risk tolerance, and time horizon as they make bond-related recommendations.