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What does a patient Fed mean for the bond market?

Submitted by Marc.Jones on May 6, 2019

After hiking rates nine times since 2015, including four rate hikes in 2018, the Federal Reserve has adopted a more patient stance with its future pace of rate hikes. Concerns about growth and tighter financial conditions will likely keep the Fed on hold for the near term.  After communicating that the gradual pace of rate hikes was likely to continue, the Fed has shifted its outlook, and the door is now open for a rate hike or a rate cut down the road.

Depending on how the economy performs, this cycle of rate hikes may already be over, and this reinforces our view that long-term yields likely peaked in the fourth quarter of last year. 

So given this outlook, we see three key takeaways for advisors as they manage their clients’ bond holdings.

One, modestly extend average duration. With long-term yields likely near their peak for this cycle, we suggest extending the average maturities of fixed income holdings. We prefer the 7- to 10-year part of the yield curve. 

This allows your clients to lock in slightly higher yields with certainty, since we don’t know when short-term rates will rise again, if at all. And longer-term maturities offer greater diversification benefits in case bond yields do move lower due to slower growth or potential stock market declines.

Longer-term bonds do have more interest rate risk, but with our view that long-term yields have likely peaked, we don’t see as much risk of price declines going forward. 

So one strategy to consider is a barbell approach. Invest some bond holdings in short-term bonds since their yields are at the highest they’ve been in years, but also focus on 7- to 10-year maturities for the slightly higher yields and the diversification benefits they offer.

Number two, we prefer fixed rate bonds over those with floating coupon rates. With uncertainty regarding the future path of short-term interest rates, we suggest shifting out of floating rate notes and invest in fixed rate bonds given their modestly higher yields.

And, third, we’re still cautious on the riskier parts of the bond market. We think it makes sense to take risk when you’re being compensated well for it, but today you’re not.

With aggressive investments like high-yield bonds or emerging market bonds, the yields offered relative to U.S. treasuries are relatively low. While a patient Fed may keep prices support in the near-term, slower growth and a slowdown in corporate profit growth prevent us from being a bit more optimistic. And with such a strong start to 2019, we see little room for price appreciation through the end of this year, and income will likely be a key driver of total returns. In fact, we see a rising risk of price declines as the year progresses.

So with the Fed on hold for the near-term and our belief that long-term yields have already peaked, consider modestly extending the average duration of bond holdings, consider fixed rate bonds over floaters, and think about moving up in credit quality from the riskier parts of the bond market. 

For more insights from Schwab, please go to our website.

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