By Portfolio Managers: Kevin Kelly & Kevin Strauss
We find corporate bonds yielding over 5% compelling in the current economic environment, particularly quality corporate bonds that mature in 3-7 years. Whether you agree with the Fed’s or the market’s more aggressive expectation for the number of Fed Funds rate cuts, both suggest bonds can offer solid, positive returns in 2024.
We like bonds because Treasury rates are above 4% across the curve. Despite Treasury rates declining in late 2023, interest rates are still near 15-year highs. Notably, the 5-year Treasury is less than 1% off its recent highs and still nearly 1% higher than any level reached from 2009 through mid-2022. These higher interest rates persist even as inflation appears to have moderated and economic growth remains positive. Whether or not the Fed has or will precisely achieve its 2% inflation target is not critical in this context.
We strongly prefer 3–7-year corporate bonds because investors can lock-in today’s attractive interest rates for some period of time. This is especially true with an inverted yield curve as intermediate rates will go below long-end rates if/when the curve normalizes. The Fed is likely done with hiking rates during this tightening cycle and the Fed Funds rate is at the highest level in over 15 years. The two most likely scenarios leading to Fed cuts are either inflation moderates towards the Fed’s targeted 2% inflation level or a recession negatively impacting growth. There is no doubt that financial conditions are much tighter than a few years ago, so many investors believe policy is restrictive to economic growth. If inflation continues to moderate under the pressure of tight monetary policy or the economy dips into recession due to tight policy, either condition will lead to rate cuts, supporting bond prices.
In 2023, intermediate corporate bonds returned more than 7%. Notably, nearly all of this return came in the fourth quarter, highlighting that when rates move, they can move very quickly. However, many people are still hiding out in money market funds, which we do not think is ideal at this point in the rate cycle. Whether the market’s expectations or the Fed’s summary of economic projections is correct, 5% money market yields are likely to end at some point in 2024. We recognize some people are using money markets as a cash alternative to leaving money in the bank at a much lower interest rate and this is understandable. However, we do not think investors should think of money market funds as an alternative to a fixed income portfolio. As a reminder, the Fed’s December 13, 2023 summary of economic projections estimates the Fed Funds rate will decline by approximately 0.75% by the end of 2024 and another 1.00% in 2025. This implies a money market rate of approximately 3.25%. Market expectations are for more significant cuts leading to an even lower Fed Funds rate. For those worried they missed the Q4 ’23 move, it is not too late to buy fixed income, but we do not suggest waiting too long.
At the same time, we also do not suggest locking in rates for 10-20 years. Buying long-term bonds exposes investors to many factors that are more challenging to predict, such as government deficits, the size of the government debt burden, long-term global growth and inflation, and the attractiveness of Treasury rates versus foreign interest rates. Predicting these factors for a decade or more is nearly impossible. We continue to like intermediate corporate bonds given relatively high interest rates versus recent history, in a moderate inflation and low growth world. A moderate duration allows investors to lock in rates for several years without being exposed to massive interest rate and credit spread risk inherent in long term bonds. Investors still sitting on the sidelines in cash or money market funds should speak to their advisors to determine whether a fixed income portfolio makes sense at this point in the rate cycle.
The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.