In today’s market, it might be tempting for investors to pivot away from fixed income assets in favor of equities. This is equivalent to driving a car by looking at the rearview mirror. Current data and market trends suggest that now may actually be an opportune time to hold or even increase your fixed income positions. Let's delve into why maintaining a strong fixed income component in your portfolio could be a strategic decision during these uncertain times.
1) Historical Returns Following Prolonged Bond Bear Markets
According to BlackRock, we are currently experiencing the longest and deepest bond bear market on record. Historical patterns, however, show that following such intense downturns, bond markets tend to recover strongly.
Source: BlackRock “Student of the Markets”, April 2024
Currently, the size of Money Market Funds is about to exceed that of Bond Funds, a situation that typically indicates a defensive posture among investors. Historically, when such a disparity occurs, bond forward returns often become highly positive.
This is because as interest rates begin to decline from their peaks, the yields on existing bonds become more attractive, prompting investors who were previously on the sidelines in money markets to shift their assets into fixed income to capture these higher returns.
This influx of capital can drive bond prices up, leading to significant gains for existing bondholders. The substantial allocation to money markets suggests that many investors are currently poised in a “wait and see” mode, potentially ready to reallocate to fixed income. That could catalyze a strong rally in the bond market once the rate environment shifts. This pattern suggests that investors who remain steadfast in their fixed income investments at present could see appreciable gains as the market corrects itself.
2) Fair Value Assessment of the 10-Year US Treasury Yield
Using the Bespoke Investment Group model to calculate the fair value of the 10-year US Treasury yield, we find that with a yield at 4.75%, prevailing market conditions are already fully priced in.
Source: Bespoke Investment Group, April 15, 2024
This level offers a potentially attractive entry point for investors considering fixed income assets. The model considers current inflation expectations, monetary policies, and economic indicators to determine a fair yield. They suggest that the current rate provides a balanced risk-return profile for new or continuing investments in long-term Treasuries.
3) Fixed Income Versus Equity Yield Comparison
Currently, the yield on the 10-year US Treasury is notably above the earnings yield of the S&P 500, a situation that harkens back to the 1990s. Following that period, the subsequent decade saw fixed income-oriented investments and conservative accounts outperform as equities went through heightened volatility and lower returns. This relative yield analysis is critical; it shows that fixed income offers a more attractive risk-adjusted return compared to equities, especially considering potential equity market corrections or periods of low returns.
Conclusions
The financial landscape, as always, is subject to rapid changes and requires constant vigilance. However, based on historical data, valuation models, and relative yield comparisons, fixed income remains an essential component of a diversified portfolio, particularly in the current market environment. Now may not be the time to pivot toward more equity-oriented strategies but rather to appreciate the stability and potential upcoming gains from diversified portfolios and fixed income investments.
As always, it's crucial to align these strategies with your individual financial goals and risk tolerance and consider consulting with a financial advisor to tailor your approach accordingly.