The Bond Investors’ Dilemma

So far, 2019 has been a very good year for bond investors. Total returns in the fixed income markets have been among the strongest in the last 10 years, driven by declines in both interest rates and credit spreads.

As the end of the year approaches, many investors may look to rebalance portfolios—that is, sell top-performing assets and invest the proceeds in lower-performing ones, to bring the portfolio back to its target asset allocation. It’s a good idea to do this on a regular basis.

However, with Treasury bond yields near all-time lows, many are reluctant to reinvest in longer-term bonds, but are concerned about the risks in higher-yielding, lower-rated bonds. Meanwhile, sitting in very short-term investments could mean lower income if short-term rates decline. What’s an investor to do?

Fixed income total returns have been strong year to date

Source: Bloomberg. Returns from 12/31/2018 through 10/11/2019. Indexes representing the investment types are: US Aggregate =  Bloomberg Barclays U.S. Aggregate Index; Short-term core = Bloomberg Barclays U.S. Aggregate 1-3 Years Bond Index; Intermediate-term core = Bloomberg Barclays U.S. Aggregate 5-7 Years Bond Index; Long-term core = Bloomberg Barclays U.S. Aggregate 10+ Years Bond Index; Treasuries = Bloomberg Barclays U.S. Treasury Index; TIPs = Bloomberg Barclays U.S. Treasury Inflation-Protected Securities Index; Agencies =  Bloomberg Barclays U.S. Agency Bond Index;  Securitized =  Bloomberg Barclays US Securitized Bond Index; Municipals = Bloomberg Barclays US Municipal Bond Index; IG Corporates = Bloomberg Barclays U.S. Corporate Bond Index; HY Corporates = Bloomberg Barclays US High Yield Very Liquid (VLI) Index; IG Floaters = Bloomberg Barclays US Floating-Rate Notes Index; Bank loans = S&P/LSTA US Leveraged Loan 100 Index; Preferreds =  ICE BofA Merrill Lynch Fixed Rate Preferred Securities Index; Int. developed (x-US) = Bloomberg Barclays Global Aggregate ex-USD Bond Index; EM USD = Bloomberg Barclays Emerging Markets USD Aggregate Bond Index. Returns assume reinvestment of interest and capital gains. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.


The answer to the question comes down to the economic outlook. Notably, the bond market’s view is decidedly gloomy, but the Federal Reserve and equity market’s outlook seems to be more optimistic.

Bond market gloom

Slowing global growth, especially in the manufacturing sector; expectations for more easing by central banks; and declining inflation expectations suggest a near-recessionary outlook. There is currently more than $14 trillion in negative-yielding bonds across the globe, and at least five major central banks have reduced policy rates to zero or below zero.

U.S. yields are higher than yields in other major countries

Source: Bloomberg. Data as of 10/11/2019.


In the U.S., the 10-year Treasury yield has fallen from a peak of about 3.25% late last year. The downtrend accelerated in the spring, causing the yield curve to invertwith long-term rates falling below short-term rateswhich historically has often been a signal of recession in the next year.

An inverted yield curve and recessions

Source: Bloomberg. As of 8/26/2019. Past performance is no guarantee of future results.


Moreover, signs of concern about the economic outlook have emerged in the credit markets, with the performance of the lowest-rated corporate bonds diverging from higher-rated bonds. Investors are requiring higher yields for the bonds in the lowest tiers of the high-yield market, reflecting the concern that a weakening economy could lead to an increase in defaults.

Lower-quality Caa-rated bond returns are lagging those with higher ratings

Source: Bloomberg. Indexes represented are the Bloomberg Barclays U.S. Corporate High-Yield Ba Rated Bond Index (BCBATRUU Index), Bloomberg Barclays U.S. Corporate High-Yield B Rated Bond Index (BCBHTRUU Index), and the Bloomberg Barclays U.S. Corporate High-Yield Caa Rated Bond Index (BCAUTRUU Index). Total returns from 12/31/2018 through 10/9/2019. Total returns assume reinvestment of interest and capital gains. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results.


Declining inflation expectations also reflect the bond market’s downbeat outlook. Various measures such as the breakeven rate for Treasury Inflation-Protected Securities (TIPS) or the 5-year/5-year forward rate for Treasuries suggest the market is pricing in a lower rate of inflation in the future.

TIPS breakeven rates are below the Fed’s 2% inflation target

Note: Breakeven inflation is the difference between the nominal yield on a fixed-rate investment and the real yield (fixed spread) on an inflation-linked investment of similar maturity and credit quality.

Source: Bloomberg, monthly rates as of 10/14/2019.


The Federal Reserve is upbeat

In contrast, the Federal Reserve’s outlook is more upbeat. Although the Fed has lowered short-term interest rates twice this year, its forecasts continue to signal expectations for firmer growth and inflation, and there is a lack of consensus among Fed officials about the need to ease policy further. As of September, the Fed’s median estimate projected no more cuts through the end of the year, but there’s a wide range of projections; seven officials do project one more cut this year. The Summary of Economic Projections indicated that gross domestic product growth would continue near the 2% level and that inflation would edge higher next year.

The federal funds futures market is pricing in more cuts

Source: Bloomberg. Futures implied rates as of 10/7/2019.


Differences between what the markets expect and what the central bank expects always get resolved eventually. While the market generally has had a better track record of forecasting the Fed’s actions in the past few years, we think it would be a mistake to be complacent. Many of the factors holding back economic growth are policy driven, such as uncertainty about the outcome of trade negotiations, which means the outlook can change abruptly.

What’s an investor to do?

We suggest investors temper expectations about returns in the fixed income markets. While we still expect most bonds to post positive returns in 2020, it is likely to be driven more by the bonds’ coupon payments rather than price gains. Over the long run, we believe staying invested leads to better outcomes for investors. For example, investors who have been keeping a lot of their fixed income allocation in cash over the past year, due to the fear of rising interest rates, missed out on the income and gains generated in the market. Moreover, high-quality bonds such as Treasuries or investment-grade municipal bonds should serve as a ballast for a portfolio by reducing volatility, especially when the stock market declines.

Here are a few steps to consider when rebalancing a portfolio:

  • To mitigate the impact that a recession might have on a portfolio, we suggest reducing exposure to the riskier segments of the market, such as high-yield bonds.
  • To mitigate the risk of rising interest rates, we suggest using a strategy like a bond ladder to spread out the maturities over time.
  • To mitigate the risk that inflation surprises to the upside, consider adding TIPS to a portfolio. Current breakeven levels are below the Fed’s 2% inflation target and the 10-year average is indicating they’re attractively priced relative to historical averages and the Fed’s inflation target.