Bonds Just Had Their Worst Year. Is it Enough to Make Them Attractive Again?

Thanks to the rising likelihood of a recession and a surge in yields, the worst may be over for fixed income.

Michael Nagle/Bloomberg

Michael Nagle/Bloomberg

The rate-hiking cycle has hit fixed income hard. But according to bond fund manager Pimco, the darkest days may already be behind us.

The harsh market conditions have created more losses in the bond market this year than in any year on record, according to Marc Seidner, Pimco’s chief investment officer of non-traditional strategies. Bonds are valued so low that they “can [be] attractive to investors who [are] focused on the long term,” he wrote in a blog post on Tuesday.

Bond portfolios have delivered positive returns for decades, thanks to the long decline in interest rates and secular disinflation. In fact, the tailwinds for the bond markets were so strong that Bill Gross, the legendary founder of Pimco, was subject to doubts over whether he generated returns above what an index fund could have provided. Yet with inflation flying high and consumer confidence plunging this year, bond markets have suffered deep losses and pushed investors to get more creative and tactical about their fixed-income investments.

Seidner, however, argues that credit investors already have a silver lining. The first indicator of a recovering bond market, he explained, is the rising likelihood of a recession. “Bonds tend to perform well during recessionary periods,” Seidner wrote. Retail sales, for example, posted an unexpected 0.3 percent decline in May as consumers battled with inflation. Home sales slowed as well in response to spiking mortgage rates. According to Richard Bernstein Advisors, investors who overreact to a fixed-income selloff amid sluggish economic activities run the risk of missing great investment opportunities.

The second indicator is the surge in Treasury yields. According to Seidner, the 10-year U.S. Treasury yield rose from 1.63 percent in January to 3.25 percent in June, bringing “unprecedented price losses on existing bonds.” But that also means that new investments now have a better starting point, he wrote.

Seidner added that when it comes to tightening monetary policies, the central bank is more aggressive than it was in the 1990s, which could help fixed-income portfolios. In 1994, Seidner wrote, the Fed raised rates by 75 basis points — the same increase it announced last week — but this time, the rate hike came earlier on, “raising the possibility that yields may peak well before the Fed reaches its ultimate policy-rate target.” He added that the backdrop for fixed-income investments could get stronger if the Fed succeeds in bringing inflation under control.

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The long-run neutral interest rate has stayed low. “That points to the Fed pursuing a restrictive policy-tightening cycle, and the projections suggest officials are unanimous in their belief that the policy rate needs to rise above neutral, despite the cost of slower growth,” he wrote.

“Over the long history of financial markets, there have been routs that have been similarly painful to the one investors are experiencing this year,” Seidner concluded. “As has happened in the past, these declines can help reset asset valuations and set the stage for better days ahead.”

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