Within our Investment Research Group (IRG), we believe a client’s asset allocation, or mix between public equities, public fixed income, and private investment strategies, should be based on that client’s goals, objectives, risk profile, and spending needs. Each of those major asset classes is meant to play a specific role in one’s portfolio.

• Public equities, particularly the high-quality public equities in which we invest, provide growth and long-term inflation protection.
• Public fixed income is intended to provide stability (through diversifying exposures and deflation protection), liquidity, and yield.
• Private and alternative investments can provide different characteristics (depending on the underlying assets), including growth, long-term or unexpected inflation protection, and diversification.

Within each of those major asset classes, we always look to optimize allocations to best position portfolios for the future. As investors are aware, fixed income has not lived up to its potential over the past decade.  However, with recent shifts in the fixed income environment, there is now a more positive outlook for bonds.

Here, we elaborate on these shifts, the “comeback” of bonds, and share how we repositioned portfolios in 2023 and how we will continue to respond moving forward.

The Bonds are Back in Town

After a decade of providing virtually no income, cash now outyields longer-term fixed income securities of the highest quality. Investors face two questions:

1. How long will the reign of cash persist?
2. Are there enough attractive opportunities in longer bonds to justify moving that cash out of the yield curve?

Dealing with the problem of low yields was a way of life in the bond market for over a decade. These are not the only issues facing investors and policymakers, who continue to grapple with many problems in the current environment. Only when the Fed had severely underestimated the inflation problem did they slam the brakes in second quarter 2023, with the most aggressive rate hikes since Paul Volcker in the early 1980s.

When Jerome Powell’s legacy is written, we are sure he would rather be viewed as a Fed Chair who overcame inflation (Paul Volcker) rather than one who was overwhelmed by it (Arthur Burns). We view the Fed’s stated strategy of “higher for longer” as a prudent way to balance their inflation goal with the risks of a hard economic landing and further trouble in the banking system.

Although inflation may remain stubborn, it is receding slowly from its decades-high levels. The investment implications of “higher for longer” and an eventual easing of policy should benefit bond investors. With higher yields, investors do not have to rely on rate cuts to earn healthy returns on their bonds.

The path away from the zero-interest rate policy (ZIRP) has been anything but smooth. Bond markets have been rattled by severe volatility, and a confluence of macroeconomic variables should keep interest rate uncertainty the norm.

The nearby list, which excludes the Covid-19 pandemic, reminds us why we avoid market timing and instead choose to focus on our credit and valuation criteria. We stick to a bottom-up process that has consistently produced benefits for our clients, and we patiently build our fixed income portfolios one bond at a time.

• Strong labor markets
• Strong housing markets
• Unions gaining strength
• On-shoring and deglobalization
• Geopolitics
• Risk of a hard landing
• Demographics and the aging population
• Migration to renewable energy
• Massive deficit spending
• Military spending
• Sticky core inflation
• Hyper-partisan politics
• Multiple wars

Benefits of Bonds

Long story short: After a long wait, the benefits of bonds in an asset allocation have finally returned. By the end of 2021, the role of fixed income had significantly diminished, and when bonds don’t produce adequate income, their utility (apart from providing liquidity) is compromised.

Fixed income cannot properly hedge declines in equities or inflation unless yields can fall sufficiently to provide meaningful price appreciation. This was one of the difficult lessons of 2022 when stocks and bonds fell together, producing a ferocious bear market.

However, with a rally in fourth quarter 2023 and predicted rate cuts in the new year, investors may be able to expect a better outlook for the fixed income market in 2024. Bonds are back, and they are providing their full range of traditional values once again.

The beauty of today’s bond market is that you can stick to the basics and still generate healthy income.

Ironically, the simplest investments of all, Money Market Funds, are now providing stiff competition to traditional bonds. Is cash risk-free? In an academic sense, yes because cash has no mark-to-market variability. But the answer is not so simple as savers endured significant punishment in the post-Great Financial Crisis world of ZIRP. While stocks and bond investors enjoyed historic bull markets, holders of cash lost real purchasing power as rates lagged inflation. 

Today’s money market rates of over 5% are enticing in the short run and probably as good as they are going to get, but if your goal is long term income stability, holding cash is getting riskier. When the Fed does lower rates, holders of shorter-duration assets such as cash will see their returns deteriorate, while investors in longer-duration bonds will benefit from having locked in higher rates for longer.

Judging Longer Term Bonds

Investors may hesitate to extend maturities when the yield curve is inverted, as it has been since July 2022.¹ When judging longer bonds, we assess two factors:

1. The yields of Treasuries relative to investor inflation expectations. This is what we call the real yield. Irrespective of tax status, Treasuries form the foundation of the U.S. bond market. On a ten-year maturity, the real rate was -1% entering 2022 – which was less than ideal, as it implied investors could expect to generate a -1% return after inflation.

As shown in the nearby chart, today, that real yield is over 2%, which is much better in a longer-term context. For perspective, the ten-year real rate has averaged 2.3% over the past 40 years.² In other words, the “new normal” appears more consistent with the pre-crisis “old normal.”

2. The range of credit opportunities, since these form the backbone of our portfolios. At the end of 2021, taxable and tax-exempt credit valuations were the most expensive we had ever experienced. We are excited that credit valuations have normalized, providing us opportunities to supplement the yields of our portfolios beyond that of Treasuries or Triple-A rated municipal debt.

When we combine these two factors, we conclude there are many attractive uses of cash today in both taxable and tax-exempt bonds. High-quality intermediate-duration tax-exempt portfolios now generate 4% yields. That is nearly 7% pre-tax for an investor in the top Federal bracket, which is not far from longer-term equity return expectations and similar to our core taxable fixed income strategy. This highlights the value of tax efficiency, which for the municipals we own, measures in the hundreds of basis points.³

Let us also not forget that the Tax Cuts and Jobs Act, which brought the top bracket down from 39.6% to 37%, is poised to expire at the end of 2025. This should further enhance the value of municipal holdings for our taxable clients.

When we invest in fixed income, we aim to be appropriately aggressive. Stretching for yield is not in our DNA. Whether in municipal, corporate, or structured securities, we always get excited to identify high quality securities that provide more yield than they should, relative to their fundamental risks. We are thankful for the wide range of opportunities that the revaluation of fixed income produced.

As we begin the new year, the best way to protect and grow capital in bond portfolios is still to do your credit homework and make sure you don’t overpay. Today’s cash yields may look attractive, but they are far from permanent. When we are not investing, we are doing our best to spread the word around about all the longer-term opportunities in front of us.