After two-year rout, it's time for advisors to consider bonds again

After seeing bond values squashed in their worst rout in U.S. history, advisors are taking the Federal Reserve's recent pause in interest rate hikes as reason to consider piling back in.

And professional portfolio builders are warning that those who are waiting for an emphatic signal about the Fed's next interest rate move before pivoting back to bonds could find themselves missing out on big gains for their clients. Speaking to the financial guru Ric Edelman in a webinar broadcast Oct. 24, David Braun — a managing director and portfolio manager at the investing firm PIMCO — said advisors should be considering bonds now even if they think another small rate hike or two is in the offing.

"Most financial advisors and RIAs that I talk to have been anti-bond for the last three or four years now," Braun said in the webinar. "And that's been a wonderful call they made on behalf of their clients. So, congratulations. But what we would say is: If you take a look at values … and unless you're calling for a meaningful increase in rates from this point forward, bonds look pretty attractive."

Braun said he and his colleagues believe that the Federal Reserve's rate increases used to fight inflation have either hit their peak or are very close to it. Next year may even see a reduction, especially if the economy dips into a mild recession, he said.

A fall in interest rates would be good news for bond holders because it would force down yields on newly issued bonds as well. That would make bonds previously issued at higher rates more valuable. Hence the investing maxim that bond prices move inversely to yields.

Historically, Braun said, investors who have done the best with bonds have bought them well before interest rates actually started to fall. Rather than being backward-looking, bond prices generally reflect predictions of what will happen with interest rates in coming years and months. So advisors who don't move until the Fed actually reduces rates will most likely be leaving gains on the table, Braun said.

"If you wait to see the whites of their eyes and for them to say, 'I'm going to cut [rates] at this meeting and the next meeting,' that's too late, because a lot of that's already priced in," Braun said.

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In a bid to combat inflation, the Fed has raised its benchmark short-term rate 11 times since the start of 2022, taking it up from close to zero to 5.25% over the course of 19 months. Those hikes came to a halt in September, when leveling-off inflation prompted central bankers to leave the rates unchanged.

Still, the steady increases have been devastating to bond portfolios.

The yield on the 10-year Treasury bond briefly exceeded 5% for the first time in 16 years in October. Meanwhile, the average annual return for BlackRock's iShares Core U.S. Bond Aggregate Bond ETF — which tracks returns on a board array of investment-grade bonds — is down by 5.21% for the past three years.

There are already signs that investors and advisors have had their appetite for bond investing whetted again. The investment and data analysis firm Morningstar reported in September that $72.6 billion flowed into taxable bond funds in the second quarter, while $25.3 billion left equity funds. 

Kevin Brady, a vice president and advisor at New York-based Wealthspire Advisors, said in an interview that investors who stuck to a buy-and-hold plan involving bonds have certainly felt some pain over the past few years. Now, if the predictions about a halt to rate increases are correct, there should be a payoff, he said.

Brady said his firm typically recommends clients put between 40% and 45% of their portfolio in bonds and the rest in stocks. That bond allocation is not only supposed to act as a cushion should the stock market crash; it's also meant to provide a steady source of income.

Brady granted that neither of those presuppositions proved well-founded over the past couple of years.

"But now both are solidly on the table again," he said. "That's why people should consider bonds in the right circumstances."

Brady said he's even talking to clients about taking cash they might have held in money market funds and high-yield savings accounts and putting it into bonds. Brady acknowledged the continued attractiveness of money markets and savings accounts that pay more than 5%. 

But those yields, he pointed, are likely to start falling as the Fed starts lowering rates. Mid-term Treasury bonds are meanwhile offering investors an opportunity to lock in a rate around 4.5% rate for anywhere from three to 10 years.

"And it doesn't have to be an all-at-once decision," Brady said. "So I've been making some moves with clients over the past several months, adding funds into a broadly diversified portfolio for exactly the reason that the higher yields aren't going to last forever."

At an online discussion on Tuesday, various Goldman Sachs executives agreed in a talk on their investment outlook for 2024 that investors who stay in cash could find themselves missing out. Ashish Shah, the chief investment officer for public investing in the Wall Street giant's asset management unit, said, "There will be some significant regret if they don't lock in the rates that are available today."

Shah said his forecast, and his colleagues' prediction for rates, is that they will stay "higher for longer." That means that, even if the Fed lowers them marginally over the coming year, they'll remain elevated above what investors were used to seeing over the past decade.

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That could make things difficult in the stock market, particularly for publicly traded companies who rely on cheap credit to finance their business. At the same time, "High nominal rates will lead investors to kind of find value in bonds in their portfolios," Shah said.

"So getting yourself back to your strategic allocations, given the moves we've had, makes a lot of sense here," Shah said.

David Demming, the founder and president of Aurora, Ohio-based Demming Financial Services, said in an interview a normal allocation for his clients always consists of a healthy share of bonds.

"I think if you go with longer maturities you will be rewarded for locking in the rate for a longer period of time, and you will make more than with cash," Demming said.

Paul Winter, the founder of Five Seasons Financial Planning in Salt Lake City, Utah, agreed in an interview that bonds belong in any balanced portfolio. But he cautioned against any notion that fixed income is capable of delivering "big gains" over time.

He pointed out that the yield on the 10-year Treasury is now running about 2% above the rate of inflation, which has been hovering around 3.5%. That's a solid return, he said, especially when it's compared with the negligible sums that bonds were paying when interest rates were near zero.

But it's hardly the sort of thing that's going to make someone rich.

"To me, this is more of a return to normalcy," Winter said.

Braun at PIMCO said he likes bond math for a simple reason. As long as interest rates are rising, bonds' values will decrease. But once those hikes inevitably level off, what went down must go back up.

"You take the pain, and you went down," Braun said. "But now you have that yield as your friend. It's a tailwind for your future returns."