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AVIOR INSIGHTS – Why Bonds Are Still Essential for Diversified Portfolios

Avior Wealth Management / Insights  / AVIOR INSIGHTS – Why Bonds Are Still Essential for Diversified Portfolios
14 Aug

AVIOR INSIGHTS – Why Bonds Are Still Essential for Diversified Portfolios

While 2023 has been a better year for bonds after last year’s bear market, rising interest rates over the past three months have acted as a headwind. The U.S. Aggregate bond index has gained 0.6% this year, down from a peak return of 4.2% in April. Similarly, corporate bond returns have receded to 1.8% from 5% prior to the banking crisis earlier this year. High yield bonds, which are volatile and often behave more like stocks, have hung onto their gains with a year-to-date return of 6.6%. At the same time, rising yields mean that bonds are able to generate more portfolio income than at any other time over the past 15 years. What do long-term investors need to know about recent swings in the bond market and how it affects their portfolios?

Several market and economic factors have created uncertainty in the bond market. First, recent events have led to swings in interest rates beginning with the U.S. debt downgrade by Fitch Ratings on August 1. This jump in rates had ripple effects across the market since U.S. Treasury securities serve as a benchmark for riskier bonds. However, just a week later, Moody’s downgraded 10 banks, placed six under review, and shifted the outlooks on 11 to negative. These ratings and outlook changes briefly renewed concerns over the financial system which caused interest rates to fall. Since then, there have been concerns around the supply and demand of Treasury securities, worries over China’s housing sector, and more.

The bond market is having a better year than in 2022 despite recent volatility

All told, these events caused large intra-day rate swings with the 10-year Treasury yield rising to 4.2%, then falling to 3.9%, before surging again over the past few days. This volatility directly impacts bonds since prices and interest rates are two sides of the same coin. In general, rising interest rates lead to lower bond prices, and vice versa. One intuitive way to understand this is that the cheaper you can buy a bond with a specified payout schedule, the higher your eventual return, or yield, will be.

Despite these changes in rates and bond prices, it’s important to maintain perspective on the bond market behavior of the past two years. Last year’s historic surge in inflation resulted in the worst bear market for bonds in recent history, as shown on the accompanying chart. This year, bond returns have mostly been positive, and the largest intra-year decline of 4% is well in-line with historical patterns since most years experience similar declines between 2% and 5%. So, while bond prices are generally much steadier than those of stocks, history shows that fluctuating interest rates result in some bond market swings each year.

The yields on riskier bonds have fallen

Second, while the Fed is expected to keep policy rates high, there is less pressure to hike rates again as inflation improves. The latest Consumer Price Index report shows that price pressures are not only easing, but that headline inflation is already back to the Fed’s 2% target when considering the latest annualized rate. Core CPI is also just under the target at 1.9% on an annualized basis and the trend is deflationary when shelter costs are also excluded. These numbers are important because they represent what is happening to consumer prices today, compared to the more commonly cited year-over-year measures that tend to be more backward-looking.

So, while the Fed has penciled in one more rate hike this year, markets believe this may not be necessary. The probability of a so-called “soft landing” has increased as economic growth has remained steady as well. This has helped to reduce credit risk concerns which were elevated during the banking crisis. As the accompanying chart shows, yields on riskier bonds have come down as recession concerns have faded and corporate earnings have beaten low expectations. Ironically, only the yields on the highest rated bonds have increased due to the U.S. debt downgrade. All in all, this means that even if a recession does occur, markets expect that it would be mild and that companies would still be well-positioned to repay their debts.

Bonds are offering attractive yields for long-term investors

Finally, investors can be better positioned to generate portfolio income today, without “reaching for yield” by taking inappropriate risks, than at any point since the global financial crisis. A diversified index of bonds now yields 5% – nearly double the 2.6% average since 2009. Investment grade corporate bonds generate 5.7% and high yield bonds 8.5%. In contrast, the forward-looking dividend yield on the S&P 500 is now only 1.9% after this year’s strong rally. This is further evidence that diversifying across stocks and bonds continues to be the best way to construct well-balanced portfolios that can achieve income and growth, while withstanding different market environments.

The bottom line? The bond market continues to face challenges due to the uncertain economic environment. Still, this year’s bond performance is a sharp reversal of last year’s bear market, and the level of volatility has been in-line with the typical year. Most importantly, attractive yields underscore the need for bonds in long-term portfolios as inflation improves and the economy recovers.


Disclosure: This report was obtained from Clearnomics, an unaffiliated third-party. The information contained herein has been obtained from sources believed to be reliable, but is not necessarily complete and its accuracy cannot be guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness, or correctness of the information and opinions contained herein. The views and the other information provided are subject to change without notice. All reports posted on or via www.aviorwealth.com or any affiliated websites, applications, or services are issued without regard to the specific investment objectives, financial situation, or particular needs of any specific recipient and are not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results. Company fundamentals and earnings may be mentioned occasionally but should not be construed as a recommendation to buy, sell, or hold the company’s stock. Predictions, forecasts, and estimates for any and all markets should not be construed as recommendations to buy, sell, or hold any security--including mutual funds, futures contracts, and exchange traded funds, or any similar instruments. Please remember to contact Avior, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you want to impose, add, or modify any reasonable restrictions to our investment advisory services. Unless, and until, you notify us, in writing, to the contrary, we shall continue to provide services as we do currently. Please advise us if you have not been receiving account statements (at least quarterly) from the account custodian. A copy of our current written disclosure Brochure and Form CRS (Customer Relationship Summary) discussing our advisory services and fees continues to remain available upon request or at www.avior.com.

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