After the FOMC meeting on 1st November, a notable positive shift occurred as the 10-year US Treasury yield fell by 60 basis points, dropping from 5% to 4.4%. This movement coincided with a remarkable recovery in the Syfe Income+ Pure and Income+ Enhance Portfolios which surged by 2.5% and 3% respectively, effectively recouping most of the losses in September.
Income+ portfolio return from 31 Oct to 21 Nov
For investors aiming to build up passive income, the current landscape presents a timely opportunity to consider investing in bonds. Here are five compelling reasons :
1. The Fed could be done with interest rate hikes.
2. Yields are at multi-year highs, indicative of strong forward-looking returns.
3. The fundamentals of bonds have been improving.
4. Bonds play a key role in diversification and capital preservation.
5. Bonds outperform cash after the peak in policy rates.
1. The Fed could be done with interest rate hikes
To counter persistent inflation, the Fed has embarked on the fastest rate hikes since the 1980s. The good news is that inflationary pressures appear to be easing. Recent data reveals that core inflation in October 2023 declined to 3.2% year-on-year, the lowest since September 2021. With this easing inflation, there’s less pressure on the Fed to keep raising rates.
2. Yields are at multi-year highs, indicative of strong forward-looking returns
Looking at historical returns, the correlation between the starting yield and the 5-year annualized return of bonds is strikingly high. Essentially, the bond’s starting yield can be a strong clue to how it may perform over the next five years. Bonds are now offering the highest yields seen since the 2008 global financial crisis. Using Income+ portfolios as a gauge, yield-to-maturity is 7.5% for Income+ Pure and 8.8% for Income+ Enhance.
Source: Syfe, 30 June 2023
3. The fundamentals of bonds have been improving
The credit quality of the bond market has been improving, with upgrade events outnumbering downgrades. After record downgrades in 2020, “rising stars” — bonds upgrading from junk to potential investment grade — have notably outpaced “fallen angels,” those downgrading from investment grade to junk. This is driven by companies’ improved fundamentals and deleveraging.
Source: PIMCO. 30 June 2023
4. Bonds play a key role in diversification and capital preservation
Similar to the aftershocks following earthquakes, the financial markets have witnessed increased asset volatility after the pandemic. In such a market condition, diversification becomes even more important. Often referred to as the “free lunch” of investing, bonds offer diversification and enhance risk-adjusted returns, underlining their importance in capital preservation.
The chart below shows the challenge of consistently picking the top-performing asset class. Instead, a 60/40 portfolio —represented by 60% allocation in the S&P 500 index and 40% in global core bonds — has often been in the top half. In the past 15 years, the 60/40 portfolio had negative returns only in 3 years, i.e. 2008, 2018, and 2022.
Source: PIMCO, 30 June 2023
5. Bonds outperform cash before the Fed’s peak rate
Compared to cash, bonds often fare better, especially late in the Federal Reserve’s rate-hiking cycle. Looking at the past seven Fed rate-hiking cycles since 1980, we find the average cycle lasts 19 months. In the early stages of these cycles, cash typically outperforms bonds because rising interest rates hurt bond prices. However, about 4 months before the Fed’s peak policy rates, bonds start to outpace cash. Given current consensus that the Fed may pause its rate hikes, now might be the time to consider rebalancing from cash to a fixed income portfolio.
Source: PIMCO, 30 June 2023
BUT, not all bonds are created equal
It is crucial, however, to recognize that bonds are not a uniform category. There are many subsectors in fixed income, each with its own risk and reward profile. Being selective is not just a recommendation; it’s a necessity. Prioritise bonds that are of high quality and have high liquidity, ensuring that they can be easily sold if the need arises. Moreover, it’s always wise not to put all your eggs in one basket; hence, striving for portfolio diversification is key. This diversified approach not only minimizes risks but also optimizes potential returns. Such a strategy aligns perfectly with the guiding principles of the Income+portfolios, ensuring that investors gain both safety and growth.