Following interest rate hikes by the Federal Reserve, bond yields have reached levels not seen in more than a decade. As the Fed potentially approaches the end of rate increases, investors may be considering increasing their bond exposure.
How long will high rates last?
For the past 15 years, interest rates have mostly remained at historically low levels. After the 2008 financial crisis, the Fed cut rates, and with low inflation, rates stayed low. Similarly, during the Covid-19 pandemic in 2020, rates were reduced to stimulate the economy, with the 10-year Treasury yield dropping to around 0.50 percent by August 2020.
However, as the economy recovered and inflation rose, the Fed began raising rates in March 2023, with inflation peaking at 8.5 percent by that time. In response to combating high inflation, the Fed swiftly increased its key rate to approximately 5.4 percent by June 2024.
The surge in rates negatively impacted bond prices in 2023, with the Bloomberg U.S. Aggregate Bond Index experiencing a 13 percent decline, marking the worst bond performance in decades. Bond prices move inversely to yields, causing prices to fall as yields rise, and vice versa.
With signs pointing to potential rate cuts by the Fed, some investors now view bonds as an attractive investment opportunity that has been absent for some time.
Is now a good time to buy bonds?
Many investors have shied away from holding bonds due to the prolonged low-interest rate environment. However, according to Collin Martin, a fixed income strategist at Charles Schwab, this trend may no longer be the case.
“While the decision to increase bond allocation rests with each investor, those who have been holding cash in anticipation of higher yields may no longer need to wait,” Martin explained. “Adding bonds to a portfolio can offer diversification benefits, especially now that they are providing some of the highest yields in years.”
Ryan Linenger, a financial advisor at Plante Moran in Chicago, sees an opportunity to reduce overall portfolio risk through bonds without sacrificing significant returns.
“The higher expected returns from bonds allow clients to consider reducing risk assets (such as stocks) and increasing their bond allocation while still achieving solid overall portfolio returns,” Linenger noted, emphasizing that allocation decisions should always align with individual client needs.
Reinvestment risk
One challenge posed by the current environment is the inverted yield curve, where long-term yields are lower than short-term yields. Typically, investors demand higher yields for longer-term investments, but this is not the case currently.
This situation may lead investors to favor short-term bonds over long-term bonds, but the decision is not as straightforward as it seems. While short-term yields are currently higher, they are also more sensitive to Fed policy, meaning these yields may decrease when the Fed eventually cuts rates.
“Once the Federal Reserve begins to lower rates, yields on short-term investments are likely to decline, potentially resulting in lower yields when maturing bonds are due,” Martin cautioned. “Intermediate and long-term Treasury yields are still close to their highest levels in 15 years, making it preferable to secure those high yields with certainty rather than risk reinvesting at lower yields after rate cuts are implemented.”
Bottom line
The decision to hold bonds and the extent of the allocation will ultimately depend on the unique circumstances of each investor. However, the rise in interest rates has made bonds more appealing than they have been in over a decade. Investors now have the opportunity to earn attractive rates on short-term cash through money market funds, while longer-term bonds offer a chance to lock in yields in anticipation of potential rate decreases.