Mid-year bond market outlook: Three sectors to watch

As inflation finally seems to be coming under control, and growth is slowing as the global economy feels the full impact of higher interest rates, 2024 could be a compelling year for bonds. Here’s what investors should understand about the outlook for the bond market and what to watch as the year unfolds.

At the beginning of 2024, bond yields, the rate of return they generate for investors, were near post-financial crisis highs¹—and for fixed-income portfolios, yields have historically served as a good proxy for future returns. Morgan Stanley research shows a strong correlation (0.94) between starting yields for the Bloomberg U.S. Aggregate Index, which is a broad measure of investment-grade bonds, and total returns over the subsequent five years. The correlations are as strong or stronger when looking at returns over six to 10 years. In other words, at current yields, there is significant opportunity for high-quality fixed income to generate attractive total returns—and reclaim its critical role providing income and portfolio diversification.

To be sure, after the bond-market rally late last year, bond investors’ price valuations assumed there would be aggressive rate cuts by the Federal Reserve, anticipating a straight line of cooling inflation without a significant decline in economic activity. They are still expecting this kind of economic soft landing. There is little room for unexpected outcomes in economic, monetary or geopolitical events, given where markets are priced. Compared to equities, though, bonds’ total returns tend to be less sensitive to interest-rate risk, because of the yield cushion that helps protect from the potential negative effects of duration risk—a cushion that remains sizable today.

One could argue that significant gains for fixed income at the end of 2023 stole away part of 2024’s potential returns, but the counterpoint is that the fourth quarter rise in bond prices and drop in yields mostly unwound third quarter moves in the opposite direction. What’s clear is that underlying inflation in the U.S. has slowed considerably, with the Federal Reserve’s preferred gauge, the core personal consumption expenditures (PCE) price index, on a downward path toward its 2% inflation target. The Fed has indicated that it has finished its rate-hiking cycle and intends to pivot in 2024.

This creates, based on historical trends, an opportune time to add duration to the fixed-income portion of investors’ portfolios.

The Fed has signaled a planned pivot from its series of rate increases. Historically, a period of rate cuts has been a compelling time to increase duration in fixed-income allocations. If rates decline over the course of the year, high-quality fixed-income portfolios of intermediate duration have the potential to generate total returns that are substantially greater than current yields. In the last five Fed tightening cycles, such portfolios have outperformed in the one- and three-year periods after the last rate hike, compared with the returns for short-term bonds and cash—in some cases, by significant margins. Investors should consider:

• reducing their cash and cash equivalents,
• extending their portfolio duration and
• locking in yields.

Seeing fixed income revert to its traditional role in portfolio diversification would be welcome, after two years in which aggressive Fed policy created a challenging environment for bond investors. In recent periods, fixed-income portfolios produced negative returns in lockstep with negative equity returns—but those days should be coming to an end. As the Fed pivots toward cutting rates, stock and bond returns should once again move in opposite directions, re-establishing a mix of the two as a linchpin of the attractive risk-return profile of a balanced portfolio strategy.

Given the potential for the bond market as inflation slows and interest rate cuts appear likely, investors can monitor potential fixed-income opportunities in three sectors.

• Intermediate duration: Duration measures a bond price’s sensitivity to interest rate changes, and intermediate-duration holdings may be attractive in a period when policymakers are considering rate cuts.
• Select sectors of investment-grade corporates. Financial sector bonds, in particular, may be attractive. Investors should assess money center banks with more than $250 billion in assets and super regional banks because they have healthy balance sheets and offer strong yields, particularly when compared to risk-free government securities. Although investment-grade bonds are more appealing than below-investment-grade bonds at current valuations, select allocation to below investment grade corporates may help enhance fixed income portfolio yields and be warranted with the current macro-economic backdrop.
• Non-agency securitized bonds: Non-agency mortgage-backed securities, asset-backed securities, commercial mortgage-backed securities and collateralized loan obligations could offer investors access to fundamentally strong collateral and cash flows at compelling long-term valuations.²

What else should investors be watching as the year unfolds?

• Central banks: A significant part of the bond market’s prospects will come down to how monetary moves stack up against the changing rate-cut expectations that investors have priced into fixed-income markets. This year, we also will be watching for central banks in different regions to potentially move in divergent directions.
• U.S. and European economies: As Europe’s growth slows more quickly than that of the U.S. economy, European fixed-income markets may be relatively more attractive.
• Default rates: While the labor market continues to show strength broadly, pockets of weakness in either corporate or consumer defaults could be a bad sign for the U.S. economic outlook.
• Geopolitics: As conflicts in Ukraine and the Middle East continue, there is potential for impacts on global growth.

¹ FRED (Federal Reserve Economic Data) U.S. Treasury Securities at 10-Year Constant Maturity, Quoted on an Investment Basis as of 12/29/2023.

² Diversification does not eliminate the risk of loss.