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Why soaring stock prices shouldn’t distract investors from bond opportunities
09 Jul 2024
Compared to US equities, the average five per cent yield offered by high-quality Investment Grade or US Treasury bonds is hard to get excited about.1 Yet, despite stock markets taking centre stage, Fidelity International’s fixed income team still feels upbeat about the prospects for bonds.
Key points
- With the S&P 500 registering strong returns over the past year, it may be tempting for investors to overlook the fixed income market.
- However, the relatively high yields and lower prices offered by Investment Grade bonds create portfolio opportunities.
- Higher yields reduce the risks posed by interest rate uncertainty and enable investors to gain exposure to a wider variety of bonds.
- Furthermore, elevated yields allow bonds to resume their traditional role as a steady, lower-risk income source.
- The potential for stock market volatility also makes the fixed income market an attractive option.
- Interest rate cut may not be imminent.
This optimism stems from the fact that it’s still possible to buy quality bonds with yields that are higher than they’ve been in years. Furthermore, prices are currently low enough to offer the potential for longer-term capital appreciation. High yields are not only a robust source of income, but they may also increase the attractiveness of bonds that are more sensitive to possible future changes in interest rates.
To understand a bond’s vulnerability to interest rate risk, the team looks at a metric known as ‘duration’, and investing in bonds with shorter duration can help reduce risk. However, today’s high yield environment makes duration less of a concern and creates potential opportunities for prospective bond buyers.
The essential role bonds play in a diversified portfolio
A combination of relatively high yields, reasonable prices, and an expanding opportunity set may not offer the buzz of a high-flying stock market. Still, it could be a good reason for investors to consider adding bonds to their portfolios.
In the first few months of 2024, stocks showed that they could swiftly move higher. But it’s worth remembering that share prices can also decline at a similar speed. For example, in 2021, stocks initially rose, yet by the summer, the S&P 500 suddenly dropped, bond prices increased, and market participants got an attention-grabbing reminder of the critical role played by fixed income. Those rising prices and falling yields meant that fixed income investors could take comfort from the fact that gains from their bonds offset the impact of tumbling equities on their portfolios.
While this ability to offer capital buffer may not be as inspiring as rising stock prices, it is still important for many investors. As baby boomers exit the workforce and those born in the late 1960s and early 1970s eye their retirement, many may be more concerned with holding on to what they have rather than pursuing growth.
Interest rate cuts may not be on the immediate horizon
Approximately half of the yield offered by a typical corporate bond is determined by the rates on 10-year US Treasury bonds, with the rest dictated by the credit quality and other corporate fundamentals of the bond issuer. The high yields that are a big part of fixed income’s current attractiveness are primarily a product of the US Federal Reserve's (Fed’s) campaign to lower inflation to around two per cent by raising interest rates and keeping them high until inflation remains subdued. However, while inflation has eased, many economic indicators underpinning the Fed’s policy decisions fail to suggest that it’s time to cut rates.
For those investors interested in US and global bonds but uncertain about the timing and impact of potential interest-rate cuts, it’s worth considering that market analysts see little likelihood of a rate reduction before the third quarter of 2024. Therefore, if you are waiting on the sidelines and holding onto cash, this could be a time to take advantage of the opportunities high-yielding bonds offer.
1 Fidelity International, May 2024
