Since March of 2022, the Federal Reserve has raised The Federal Funds Rate an unprecedented 525 basis points (5.25%). These interest rate hikes have led to the highest yields the bond market has experienced in over 15 years. Real yields (the difference between a bond’s yield and inflation) have turned decidedly positive as inflation has fallen from its peak. Bonds are once again an asset class that can provide a meaningful return to portfolios.
In the fixed income markets, duration is a measure of sensitivity to changes in interest rates. It measures how long it takes, in years, for an investor to be repaid what they are owed from the borrower. With the significant rise in interest rates, we believe it is time to start extending duration in bond portfolios as we are nearing what we believe will be the peak of rate increases by the Federal Reserve. Extending duration represents an opportunity to lock in higher rates and reduce reinvestment risk.
We could see additional rate hikes (1-2) by the Fed if inflation continues to remain well above the committee’s 2% stated target, but we believe we are closer to the end than the beginning of the current tightening cycle. Even with the end of the cycle in view, we believe we are in a ‘higher for longer’ rate environment by the Federal Reserve, which should afford bond investors an opportunity to continue to produce higher income from their fixed income investments.
With the recent increase in long-term yields, the 5-year Treasury yield is at 4.4% and the 10-year Treasury yield is at 4.2%. These rates allow investors that have been sheltering in short-term bonds to extend out to lock in higher yields for longer. To mitigate this reinvestment risk on shorter-term bonds, we favor a laddered bond portfolio approach. In a laddered bond portfolio, bond maturities are staggered, giving investors exposure to multiple maturity points on the yield curve. In addition, with this approach, investors will have bonds maturing on a regular basis, giving the opportunity for re-investment or re-allocation based on the investor’s needs.
A high quality, well-diversified laddered bond portfolio in today’s yield environment can yield 5.0-5.5% on a pre-tax basis. In our opinion, a diversified bond portfolio, mixed with equities and alternatives, can help improve the risk-adjusted returns of a portfolio without the same return give up of fixed income’s recent low interest rate past. Bonds are back.