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In March of 2022, the U.S. Federal Reserve (Fed) began its fight against the highest inflation the U.S. had seen in decades, raising the federal funds rate for the first time since 2018. What followed over the next 15 months was the most aggressive hiking campaign by the Federal Open Market Committee (FOMC) since the 1980s:

For diversified investors with bond exposure, this resulted in one of the most difficult bond environments on record given the relationship between rising interest rates and falling bond prices. As the Fed raised interest rates aggressively, bond yields followed suit, causing their prices to fall dramatically.Today, the situation shows signs of changing. Specifically, we believe that bond investors who fled for the safety and high rates of cash-like investments over the past couple years may find better balance from bond returns going forward. Consider that:

We’ll expand on these points and their implications for bonds going forward in the sections below, providing additional context and talking points to help with client conversations on the case for fixed income and diversification.

History shows higher rates led to higher returns
To help illustrate the relationship between starting yields and future bond returns, we can lean on history as a guide. The graph below plots the month-end yield (x-axis) and subsequent 5-year returns (y-axis) of a diversified portfolio of high-quality bonds, as measured by the Bloomberg Aggregate Bond Index, by decade since 1980.You’ll see we’ve experienced a wide range of interest rate levels over the years, with some decades much higher than others, yet the graph clearly illustrates the positive relationship between starting yields and future bond returns.In the 2000s, for example, bond investors were able to purchase a bond portfolio with interest rates between 4.5%-5.5%. Those same investors averaged a 5-year return of 5.6%, slightly above the interest rate they started with: Source: Barclays and Morningstar Direct, as of 6/30/2024. U.S. Bond: Bloomberg U.S. Aggregate Bond Index. Yield: Yield-to-worst; Forward Return: 5-year, annualized, starting in the following month of each yield measure. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. While today’s environment doesn’t provide bond investors with the same potential return opportunity as the 1980s, we do find ourselves back to higher interest rate levels like those in the 2000s. History suggests that could result in higher returns going forward. 

Bond math: Applying it to where we stand today
The Fed has closely monitored the state of inflation in the U.S. and the health of the economy over the last few months, and will continue to do so the rest of this year.If inflation and/or the economy continues to show signs of slowing, the Fed will likely start cutting interest rates, which may bode well for bond investors. However, if inflation and/or the economy reaccelerates, and rates remain at their current levels or even trend higher, then bond investors today will be in a much better position than they were just a few years ago.Why? How can today’s bond investors benefit from both declining and rising inflation? The key reason is that with bond yields at 5%, the compensation investors receive to own bonds is much higher regardless of where rates go next. To understand why this is the case, it may be helpful to revisit the fundamental relationship between changes in interest rates and the impact they have on bond prices.Holding all else equal, there are three potential paths rates may take over the next 12 months. Interest rates may increase, decrease, or stay the same. The graph below illustrates how the direction of change in interest rates could impact bond returns experience by investors over the next 12 months:
Source: Barclays. Data as of 6/30/2024. U.S. Aggregate Bond: Bloomberg U.S. Aggregate Bond Index. Yield: Yield-to-Worst of the Bloomberg U.S. Aggregate Bond Index. Duration: Modified Adjusted Duration of the Bloomberg U.S. Aggregate Bond Index. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly.
Recently, inflation and economic data have started to soften, and markets are now expecting the Fed to cut rates next month. While we cannot predict the future path of interest rates and the speed with which they get there, signs are pointing to a lower destination. As the bond math above indicates, it could be a windfall for those who have stayed patient with their bond allocations.

Duration: Not all bonds are created equal
This benefit is also more attractive as you consider bonds with higher sensitivity to interest rate moves. For instance, bonds with longer maturities tend to have higher levels of duration (interest rate sensitivity) and would be expected to offer a larger benefit if rates were to fall over the coming months.Currently, the federal funds target rate is 525 to 550 basis points. Where does the market expect it to be a year from now? According to CME Group’s Fed Watch, by next July there’s an 85% probability the target rate will be in the range of 375 to 475 basis points. This implies 75 to 175 basis points of interest rate cuts over the next 12 months.Now, if the last few years have taught us anything, does anyone know exactly where rates will be in the next year? Of course not. However, it’s safe to say the market currently expects them to be lower than where they are today. If you agree with this viewpoint and are willing to accept some volatility, adding more duration to your fixed income allocation has the potential to increase returns. The table below summarizes the bond math (as discussed above) for short duration, intermediate duration and long duration bonds. If interest rates decrease as the market expects, long duration bonds could potentially provide equity-like returns for investors.
Source: Barclays. Data as of 6/30/2024. U.S. Aggregate: Bloomberg U.S. Aggregate Bond Index, U.S. Short: U.S. Aggregate 1-3 Year Index, U.S. Intermediate: U.S. Aggregate 5-7 Year Index, U.S. Long: U.S. Aggregate 10 Years or Higher Index. Yield: Yield-to-Worst of the Bloomberg U.S. Aggregate Bond Index. Duration: Modified Adjusted Duration. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly. https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html 

Implications for financial plans/diversified portfolios: Increased likelihood of success
The silver lining for diversified investors is that higher interest rates are a GOOD THING for their portfolio’s chances of achieving their financial goals. Let’s walk through a quick example to see the real-world implications.Consider a client who is saving for retirement. Based on their current savings and future spending needs, a 7% average return over their investment horizon should be sufficient to meet their retirement goals.A few years ago, when interest rates were much lower, that client needed two things from their retirement portfolio:

As the graphic below illustrates, to achieve a 7% total return when assuming bond returns of only 2%, this client not only needed to take on more risk through a higher stock allocation (60% to 80% stocks), but was also dependent on a great result (10%-12% return) from an asset class that, historically, has a wider range of returns:
Thankfully, stocks delivered (and then some) for most investors over the past few years, but relying on best-case scenarios from a riskier asset class like stocks is not exactly a comfortable way to reach your financial goals.This is especially true as you introduce new variables to the situation like a shorter time to retirement (i.e., sequence risk), or an inability to increase your savings rate to cover shortfalls from the returns generated by the portfolio.Now, let’s apply that same client situation to a higher bond return assumption of 4% instead of 2%. Going back to the table, you can see how much the picture changes. What are the implications of the higher return for the bond portion of the portfolio?

The primary objective for any investor saving for their financial goals, especially one as important as funding their retirement, should be to achieve the rate of return needed with the highest likelihood of success.Hopefully, this exercise helps demonstrate why increasing allocations to bonds today can potentially deliver just that.

The bottom line
While the future path of interest rates remains unclear, bonds now offer investors a more meaningful compensation. This compensation becomes more attractive for longer maturity bonds and also helps achieve total portfolio return targets at a lower level of risk.More By This Author:U.S. Inflation Falls To Lowest Level In Three Years
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