Fixed income markets have only recently recovered their recent rout, but more upside may be ahead, a strategist said.
The Fed’s likely done with rate hikes, which should eliminate the biggest headwind for bond investors.
LPL Financial laid out four things investors should watch as 2023 winds down.
The bond market turmoil that kicked off in October marked one of the worst sell-offs in history, but as 2023 nears its end, a market veteran says there’s reason for optimism in fixed income heading into the new year.
In a note last week, Lawrence Gillum, chief fixed income strategist for LPL Financial, pointed out that bonds have only recently turned positive for the year.
He laid out five reasons the current set-up bodes well for investors, starting with the end of the Federal Reserve’s rate-hiking campaign.
“The biggest headwind to the fixed income markets over the last few years has unequivocally been the Fed,” Gillum said. With disinflation continuing at a steady clip, he said the central bank is likely finished with its monetary policy tightening.
“[W]e think the Fed is likely done, which should eliminate the biggest headwind to fixed income markets,” he said.
Second, Gillum pointed to the asymmetric risk-return profile for bonds, largely thanks to the higher “yield cushion” that can offset higher interest rates.
“The higher income component serves as a ‘hurdle rate,’ or a yield cushion, that will need to be eclipsed before further losses are realized,” he said. “As such, these higher hurdle rates may decrease the probability of losses due to an increase in interest rates while at the same time these higher starting yields increase the probability of annual gains.”
Third, the strategist said bond investors could see equity-like returns — without equity-like risks.
LPL Financial holds a base case for the 10-year Treasury to hover at 4.25%-4.75%, but it maintains that a sustained drop in yields could lead to high single-digit or low double-digit returns in the next 12 months for fixed income investments.
“[I]f the economy slows and the Fed cuts rates more than we expect next year, these high-quality fixed income sectors could generate 12%–13% type returns (no guarantees of course),” Gillum wrote in the note.
And fourth, the present fixed-income landscape will open the door for income-oriented investors to generate income again, in his view. Right now, he said bond investors can build a high-quality portfolio of US Treasurys, AAA-rated mortgage-backed securities, and short-maturity investment-grade corporates.
“Investors don’t have to ‘reach for yield’ anymore by taking on a lot of risk to meet their income needs,” Gillum said. “And for those investors concerned about still higher yields, laddered portfolios and individual bonds held to maturity are ways to take advantage of these higher yields.”
Gillum writes that as markets transition into a more normal rate environment, bonds investors are in a good place as 2023 winds down.
“That’s not to say there won’t be volatility, there will be, but we think the risk/reward for fixed income is as attractive as it’s been in some time, for which we are thankful.”
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