Despite market volatility, bonds remain resilient investments over the longer term

Bond yields are currently at their highest levels since 2007 and to put the recent sell-off in perspective, US Treasury returns have been the worst since 1787 when a fledging US Republic ratified its constitution. Bond bears in the short term could push yields on 10-year Treasuries over 5%. Still, we believe owning bonds over the medium and long term will reward investors well, both in an absolute sense and relative to other asset classes, including cash and equities.

In the wake of the recent bond market rout, it’s important for investors with long-term outlooks to maintain their patience and stay committed to a long-term approach to interest rates.

Understandably, that could prove difficult as investors have watched yields on 10- and 30-year US Treasuries rise to their highest levels since before the Global Financial Crisis. The massive sell-off has the potential to diminish the trillion dollars’ worth of sovereign and corporate bond investments that banks, insurers, pension funds and asset managers have amassed.

However, investing is a long game. Bonds remain a good bet for the medium and long term, given the economic environment taking shape. While inflation may be more elevated than previous decade, yields - both real and nominal - on higher quality bonds now stand at their highest levels in 15 years and screen cheaply not just in an absolute sense, but also relative to other asset classes particularly equities. Additionally, with growth and inflation slowing and the Federal Reserve (Fed) at or approaching the end of the hiking cycle, historically this has been when investing in bonds has been the most rewarding.

Following the Fed’s September meeting, the narrative appears to have shifted away from falling inflation and potential interest rate cuts toward higher rates for longer, significantly higher supply and increasing term premium and risk associated with bonds. In response, yields on 10- and 30-year US Treasuries reached 4.75% and 4.88% in early October, respectively, their highest levels since 2007. If we look at forward market expectations of interest rates, they are not expected to drop below 4% over the next decade. Given all the political, economic and structural gyrations likely over the next decade, this appears a very aggressive assumption.

Investors should bear in mind some data points that support this outlook:

• Valuations appear positive: Nominal yields are in the 100th percentile (most attractive) over the last decade and in the top quartile over the last 20 years (Figure 1)

Figure 1: Yields ranked over time

^{Source: Bloomberg and ICE BofA as of September 30, 2023. Indices used: Bloomberg US Aggregate Index, Bloomberg US Treasury Index, Bloomberg US Long Treasury Index, Bloomberg Securitized Index, Bloomberg Municipal Index, Bloomberg US Corporate Index, ICE BofA US Corporate 1-3 Year Index, Bloomberg US Long Corporate Index and Bloomberg US High Yield Index. Past performance is not a guide to future results.}

• A yield’s starting point matters to returns: Even if yields rise, returns will likely be positive over a 1-year period for short and intermediate bonds (and can be significantly so if they stabilize or fall)
• Value relative to equities is very cheap: Equity Risk Premium (earnings yield minus yields on 10-year Treasuries) sits at a 15-year extreme; bond values haven’t been this cheap compared to equities since 2007 (Figure 2)

Figure 2: Equity Risk Premium (30-day moving average)

^{Source: Bloomberg as of September 30, 2023. Equity risk premium is calculated using the S&P 500 Index forward earnings yield minus the 10-year Treasury yield. Shown for illustrative purposes only and should not be viewed as a recommendation to buy or sell any security.}

• Inflation and growth have peaked: While many expect a soft landing today, we expect lower growth and higher volatility next year
• Historically, bond yields peak roughly 12-18 months after the first rate hike, which was in March 2022. Additionally, rates tend to peak before the Fed has completed the hiking cycle
• Risk assets (equities and corporates) have a negative outlook: Real yields sitting above 2% likely accelerates a risk-off approach

The trends we described earlier still show that bonds will remain a good bet for the medium and long term. Stress is understandable, but with a yearslong perspective, now isn’t the time to panic.