When Bonds Stopped Doing Their Job, Investors Searched for Alternatives. Now the Pendulum Is Swinging Back.

After consecutive rate hikes, bonds may regain their place in the traditional 60/40 portfolio.

Illustration by II

Illustration by II

It’s been a historically bad year for the bond markets. But with valuations in the tank thanks to the Fed’s interest rate hikes, and new securities becoming available at attractive yields, investors may finally be ready to test the fixed-income waters again.

Trevor Graham, managing director at TIFF Investment Management, an outsourced chief investment officer firm, said the team is considering allocating more capital to the bond market as rate hikes continue — a reversal of the firm’s investment strategy from just a few months ago. In June, TIFF replaced some of its fixed-income allocation with hedge funds whose mandate is similar.

“When the return on bonds was close to zero, the hedge funds were really attractive on a relative basis,” Graham said. That’s not quite as true anymore. Still, the market shift is still in its early days. “We haven’t made major changes to the portfolio, but this is something we are keeping an eye on.”

A few months ago, TIFF argued that some hedge funds could offer diversification benefits similar to what bonds once offered when yields were higher. Now, with rates back at attractive levels, TIFF thinks that fixed income can once again help diversify stock-heavy portfolios.

Michael Contopoulos, director of fixed income at Richard Bernstein Advisors, agrees that the bond market has become attractive again due to the consecutive rate hikes. “Yields are at pretty reasonable levels [that] we haven’t seen in a very long time,” he said, adding that this is now a good opportunity to buy longer-term fixed income.

Contopoulos believes that the Fed will probably stay restrictive in 2023. “I think we’re on the path of [having] several years where fixed income looks pretty attractive,” he said. “We’re bound to enter into an earnings recession...In that case, credit spreads will widen, and long-term interest rates should stabilize, if not fall, meaning [bond] prices should go up.”

In its latest quarterly outlook, Aegon Asset Management, an investment firm managing $329 billion in assets, also advised investors to overweight fixed income. “The recent rise in sovereign yields and spreads has made fixed income an attractive alternative relative to equity risk,” the report said. Within fixed-income, the manager favors investment-grade bonds.

“We think we are going to have a recession next year,” Frank Rybinski, head of macro strategy at Aegon, told II. He added that earnings are expected to drop further in 2023, which could cause an even more significant correction in the stock market. In a recessionary environment, he suggests that investors adopt a defensive strategy, which involves shifting from equities to fixed income and from low- to high-quality bonds.

“It won’t be a rosy story next year. We want to be up in quality,” Rybinski said.