A New Era for Bonds: Higher Rates and Long-Term Returns

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The bond market is entering a “new era” where higher rates are expected to result in better long-term returns for investors. Vanguard, the world’s second-largest asset manager overseeing $7.8 trillion globally, believes that even in the higher-quality sectors of the market, investors can find tremendous value.

Short-Term Volatility vs. Long-Term Potential

Sara Devereux, global head of fixed income at Vanguard, acknowledges that short-term volatility is likely to persist. However, she advises investors to look beyond the noise and focus on the long term. Vanguard expects interest rates to remain higher for longer than previously anticipated and predicts a shallow recession in mid-2024.

Prioritizing Quality Amidst an Impending Recession

Given the current position in the economic cycle and the anticipation of an upcoming recession, Vanguard emphasizes the importance of prioritizing quality. This means investing in Treasuries, agency mortgages, and munis, alongside investment-grade corporate credit.

The Fed’s Interest Rate Policy

Devereux suggests that the Federal Reserve is nearing the end of its hiking cycle, as short-term rates have surpassed those of longer-dated debt. She explains that the relative advantage of short-term government bonds can quickly fade, and investors benefit more when they lock in higher rates for longer durations.

Uncertainty Surrounding Future Rate Hikes

While Devereux does not anticipate a rate hike at the Fed’s next policy meeting, she does not rule out the possibility of an increase in December. However, she cautions that delaying rate hikes for too long may have disruptive consequences when they do occur. The timing of future rate hikes is crucial, as a prolonged pause followed by a restart would create a higher threshold for further increases.

Consistent with Vanguard’s Outlook

Vanguard’s latest quarterly outlook concurs with Devereux’s analysis, stating that the Fed is unlikely to lower interest rates before mid-2024. The year has been challenging for bond investors, with falling prices accompanying rising yields.

In this new era for bonds, while short-term volatility persists, long-term potential for higher returns exists. Vanguard advises investors to remain focused, prioritize quality, and lock in higher rates for longer durations.

The Changing Landscape of Bond Prices

Prices of Treasuries have experienced three consecutive years of declines, and the same fate awaits other bonds such as mortgage-backed securities and high-quality corporate debt.

Vanguard’s Perspective

According to Vanguard, U.S. government bonds will continue to see strong long-term demand, with a fair-value level for 10-year Treasury rates estimated at 4.50%.

Vanguard considers high-quality corporate bonds to be an attractive investment opportunity. The firm is also positive about mortgage-backed securities, emphasizing their high-quality credit profile, diversification, and liquidity, particularly in the current environment.

Municipal Bonds and Preferred Investments

Within the municipal bond market, Vanguard favors longer-term investment-grade bonds. The company believes that many companies bolstered their balance sheets by borrowing before the Federal Reserve’s hiking cycle began. In terms of municipal bonds, Vanguard finds valuations to be strong in longer-term investment-grade issues with ratings below AAA.

Thoughts on High-Yield Bonds

Vanguard maintains a neutral stance on high-yield bonds. While there are potential opportunities in this market, investors need to exercise selectivity. It is crucial to avoid purchasing every household name in the index and instead be highly discerning when choosing the best names. Vanguard stresses that avoiding losers is just as crucial as picking winners.

Sectors to Monitor

Vanguard is keeping a watchful eye on sectors that it currently avoids due to their potential impact on other markets. These include companies with weak balance sheets and commercial real estate. The firm expresses specific concern about commercial real estate, citing vulnerability due to interest rates and reduced office demand post-pandemic. Furthermore, regional bank stress is linked to this vulnerability. Despite these concerns, Vanguard believes any impact will likely be contained and not have a significant knock-on effect in other parts of the market. Consequently, they have reduced their exposure to riskier commercial mortgage-backed securities earlier this year.

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