Fixed income investors have gone through a rough ride over the past 2 years, with surging inflation and aggressive interest rate hikes from the US Federal Reserve (Fed) resulting in the biggest bond bear market in history.

And bond markets have hit another rough patch recently, with a renewed sell-off over the past few months contributing to a jump in longer-term yields. Case in point: 10-year US Treasury yields grazed 5% in mid-October for the first time since 2007 amid increased uncertainty over the direction of the economy.

As a fixed income investor, how should you think about navigating these choppy waters? In this month’s CIO Insights, we dig into the latest developments in the bond market, and examine where the risks and the opportunities lie in fixed income.

Key takeaways:

• In recent months, yields on longer-term bonds have risen significantly compared to shorter-term yields – a rare situation known as a “bear steepening” of the yield curve. What’s more, this comes at a time when the yield curve is inverted (where longer-term rates are lower than shorter ones). In 3 of the 4 times that a bear steepening has occurred during an inverted yield curve, this has preceded a recession.

• More recently, dovish signals from the Fed suggest that it’s likely to press pause on its hikes, but keep rates elevated to prevent a rebound in inflation. A rate cut also appears to be off the table as unemployment remains low.

• A “higher-for-longer” scenario for interest rates means that yields on short-dated bonds, like US Treasury bills (T-bills), will likely stay attractive in the near term – something we’ve flagged for much of the past year.

• Our investment framework, ERAA™, is signalling that the current economic regime, stagflation, isn’t favourable for longer-duration bonds just yet. That said, our long-term valuation model suggests that the asset class has become attractively priced, and can provide strong returns should the economy cool further and tip into a recession. 

• A concern for investors over the past few months has been the US’s fiscal health, and how much debt it may need to issue. That’s because a much bigger supply of Treasuries would push prices down and yields up. But our analysis suggests that at a 5% yield, the market has already “priced in”, or accounted for, much of that risk.

• Looking ahead, longer-dated bond prices may remain choppy, and it could still take some time for the bottoming-out process to play out, given labour market strength. For now, as our framework still indicates that short-dated bonds have better risk-adjusted returns, our portfolios remain overweight on this asset class.

A “bear steepening” of the yield curve is a rare occurrence, and points to a weaker US economy

The rapid increase in longer-term bond yields over the past few months – in contrast to shorter-term yields – has been one of the biggest market developments for investors. The yield on 10-year US Treasuries, for example, climbed from 3.8% at the start of July to nearly 5%, an increase of 1.2 percentage points. That compares with a much shallower 0.3 percentage point rise in 2-year Treasury yields, from 4.9% to 5.2% over the same period.

This “bear steepening” of the yield curve – where longer-term interest rates rise more rapidly than shorter ones – is a relatively rare occurrence. Including this latest episode, they’ve only been in this state less than 10% of the time since the mid-1960s. There are a number of reasons why they can happen – from expectations of stronger growth or higher inflation, to supply-demand dynamics in the bond market (more on that later).

And such a rapid rise in longer-term rates can have a real impact on the economy. For example, this means higher borrowing costs for households and companies – think mortgages, or loans for business expansion. It can also mean losses for investors with longer-dated bond investments (remember Silicon Valley Bank?). All of this can weigh on growth.

The current bear steepening is especially notable because it’s happening at a time when the US economy is cooling and the yield curve is deeply inverted. Such instances of bear steepening are even more rare. And due in part to the impact of higher rates on the economy, a steepening of the yield curve under these conditions preceded a recession in 3 of the 4 times it occurred. During the fourth time, GDP growth slowed sharply, but avoided recession.

Dovish Fed and softening economic data point to a peak in short-term rates

Recent weeks’ developments have signalled another shift for market expectations – suggesting that rates are likely near or at their peak.

At the Fed’s last meeting in early November, dovish comments from Chair Powell sent a strong message that the central bank is done with its rate hike cycle. Specifically, Powell seemed to suggest that the Fed’s past projections of another rate hike by year-end may not pan out. As of mid-November, futures markets suggest that the odds of another hike this year are essentially zero.

A series of weaker economic data in recent weeks also highlights that the economy is slowing. The October jobs report showed the labour market has started to cool, with jobs gains decelerating and the unemployment rate unexpectedly rising to 3.9% (though we should note that this is still quite robust, from a historical perspective). The ISM Purchasing Managers’ Indexes (PMIs), meanwhile, showed the manufacturing sector contracted further, alongside weaker momentum in the services sector. The latest headline inflation reading also continued to trend down, to 3.2% year on year in October.

In total, these data points add to the case for the Fed to hit pause on rate hikes. And as the US unemployment rate remains close to its historical lows, wage growth is high, and inflation, though slowing, is still above-target, rate cuts seem unlikely for now.

Longer-duration bonds are cheap, but risk-reward still favours short-term bonds

What do these developments mean for your fixed income investments? 

For much of the past year, we’ve said that short-duration bonds are one of the most attractive asset classes in this environment from a risk-reward perspective. We still believe this is true. Take T-bills: yields have held around 5.4% or higher since July, and are likely to remain elevated over the next 6 months or so as the Fed keeps rates “higher for longer” to prevent a rebound in inflation.

Looking further down the yield curve, the recent rapid sell-off in bonds has made longer-duration Treasuries more attractive given their cheaper prices. Our long-term bond valuation model, illustrated in the chart below, shows that 10-year Treasury bonds are nearly 1 standard deviation below their long-term average. This suggests they’re relatively cheap, historically speaking.

That said, our investment framework, ERAA™, continues to signal that the current economic regime, stagflation, isn’t favourable for longer-term bonds just yet due to a lower risk-reward profile relative to shorter-duration assets. But given their attractive valuation, the asset class has the potential to provide strong returns once the economy cools further. 

And if you take a very long-term perspective, this jump in yields also creates a runway for bond returns in the years ahead (see our H2 2023 outlook for more on that).

With much of the risk priced into 5% yields, the worst may be over for bonds

One of the main explanations for the recent bond sell-off was investor concern over the US government’s fiscal health and the risk of a tidal wave of bond issuance in the decades to come. Take the trajectory of US government debt: according to Congressional Budget Office (CBO) projections, US debt will rise to 118% of GDP in 2033, or a 20 percentage-point (ppt) increase from 98% in 2023.

To understand if a 5% long-term bond yield prices in this risk, let’s do a back-of-the-envelope calculation. If we assume a long-term inflation rate of 2% (the Fed’s target) and a neutral real interest rate of 0-0.5% (historical averages), that would imply that the market is pricing in an additional 2.5-3% to account for other risks. This additional yield is known as the “term premium”, and is the extra compensation required by bond investors in exchange for the uncertainty of locking up their money for a longer period.

Looking back on history, the last time we saw a term premium of 2.5% or more for an extended period of time was during the 1980s. But that was also a time when inflation was consistently above 5%, interest rates were much higher, and the Fed was much more hawkish. In addition, using estimates from an IMF study, we find that a 20 ppt increase in US debt to GDP like that estimated by the CBO would imply an increase in the term premium of only 0.4% to 1.4%.

Put together, the above suggests that at a 5% yield, the market has already priced in much of the risk tied to US bond supply and demand dynamics. Even so, given the strength in the US labour market and stickiness in inflation, we expect that prices for longer-term bonds could still take some time to bottom out.

How StashAway can help you navigate the bond market

There are a number of investment solutions on the StashAway platform to help you navigate the bond market.

For investors seeking diversified portfolios to build long-term wealth, our ERAA™-managed General Investing portfolios remain defensively positioned to guard against the uncertain macroeconomic environment. Specifically, with the yield curve still inverted and cash equivalents like T-bills still yielding higher than both inflation and longer-term bonds, our investment framework remains overweight on short-term bonds due to their better risk-adjusted returns.

This defensive positioning has helped us to beat our benchmarks amid the turmoil of the past year – particularly in our lower-risk, bond-oriented portfolios (see our Q3 returns report for more details).

For investors who want to build a position in bonds given their cheaper prices and attractive yields, you can consider our Passive Income portfolios.

And finally, for investors who want more exposure to high-yielding, low-risk US Treasuries, our USD Cash Plus portfolios have a projected 5.4% yield to maturity (as of October 31, 2023).

Riding the market’s ups and downs are part and parcel of building wealth over the long term. What’s important is to have a portfolio of assets that balance risk and reward in a way that keeps you invested. That way, when you zoom out over the course of your entire investing journey, the short-term waves in the market start to look a little smaller.

*Disclaimer:

Our same-risk benchmarks are proxied by MSCI All Country World Equity Index TRI for equities (prior to 1 March 2023 are proxied by MSCI World Equity Index TRI) and FTSE World Government Bond TRI for bonds. The benchmarks we use have the same 10-years realised volatility as our portfolios.

We calculate these returns before fees.

Past performance is not a guarantee for future returns. Please study the product’s features, return conditions, and relevant risks before making an investment decision.