Bond Market Experts Offer Road Map for What Lies Ahead

If anyone needed confirmation about the varied ways that markets are made, the following should suffice. 

To help gauge the level of risk and opportunities spreading across the fixed-income markets, etf.com gathered perspectives from seven bond market professionals on what the near-term future looks like for investors. 

Michael Rosen, chief investment officer, Angeles Investments 

What are the biggest risks facing the bond market? 

The yield curve is still inverted, with five-year yields 100 basis points below six-month T bills. The market expects the Fed to begin cutting rates in the second quarter of 2024 and expects the Fed funds rate to be 4.5% by the end of next year, 100 basis points lower than today. 

So, the biggest risk remains what it has been for over a year; that the Fed does not ease rates on the timetable the market expects.  

Where are you finding opportunities to invest in the bond market? 

We continue to see value in staying short duration. There are pockets of attractive yields in high-quality collateralized loan obligations and asset-backed securities, and we have been allocating more in these areas. 

Jack Schanne, chief investment officer, Cary Stamp & Co. 

What are the biggest risks facing the bond market? 

The biggest risks facing the bond market are inflation that exceeds expectations, high defaults caused by a challenging economy and additional bank failures.  

Where are you finding opportunities to invest in the bond market? 

We are finding opportunities in short-term Treasuries since their yields are attractive on a risk-adjusted basis, longer-term individual high-quality corporate bonds, to protect against a falling rate environment and zero coupons that could have a substantial upside for investors willing to take on more risk.  

Stuart Katz, chief investment officer, Robertson Stephens  

 What are the biggest risks facing the bond market? 

We believe long yields are rising for several reasons: Treasury supply is larger than expected with little concern for fiscal restraint, stronger-than-expected growth, September Fed Dot Plot and less foreign buyers including China and Japan indicating potentially loosening its yield curve control policy. 

If payrolls continue to rise at an elevated pace, then we believe the Fed might be tempted to add another rate hike. 

Upward pressure on rates is causing the banking sector, domestically and aboard, to endure more mark-to-market losses, which may lead to more volatility in markets similar to what we saw in in the first half of 2024. 

Political risks domestically, including a possible government shutdown in November, and aboard—Middle East, Ukraine and China—may also create elevated volatility. 

Where are you finding opportunities to invest in the bond market? 

As the economy continues to decelerate, we’re finding value in targeted high-quality segments of the public fixed-income market, including municipal bonds, mortgage-backed securities, and investment-grade corporates.  Starting yield has historically been a major driver of bonds’ five-year total returns and investment-grade corporates are trading at prices and yields not seen in years. 

We believe deliberate exposure to certain municipal bonds constructed in separately managed accounts modestly below duration benchmark and mortgage-backed securities are attractive. 

In a late-cycle environment, having an intentionally diversified exposure across alternative credit strategies may help maximize the different roles that alt strategies can serve within a portfolio, including offering potential downside protection, more durable total return and providing less correlated differentiated sources of return compared with the public market. 

Jennifer Hutchins, co-chief investment officer, Avantax 

What are the biggest risks facing the bond market? 

The biggest risks I see are that inflation and economic growth do not cool to the level the Fed wants, and we see the Fed increase rates further. 

Where are you finding opportunities to invest in the bond market? 

We are finding opportunities in investment-grade securities and Treasuries. The five- and 10-year Treasury yields are at the highest levels that we have seen in about 16 years. 

While many people are focused on the short end of the curve, we are focused more on the middle to longer end of the curve; hoping to lock in these attractive yields while working to de-risk portfolios. 

Michael Buchanan, co-chief investment officer, Western Asset Management 

What are the biggest risks facing the bond market? 

Fed policy is currently restrictive with real rates near 2.5%. Given our expectations for slower economic growth combined with inflation that’s rapidly trending toward 2%, we believe that Fed policy bias should begin shifting toward a more neutral stance in the near term, with a more accommodative destination longer term. 

However, risks remain high that the Fed could remain at current restrictive levels for too long and jeopardize the economy outlook. The Fed often references how central bank policy works with "long and variable lags." We are already witnessing some signs of stress in the economy, most notably the consumer who are facing headwinds from higher gas prices, higher rates, depleted savings and higher credit card balances. 

Should the Fed remain overly restrictive for too long, the path for the economy could slip toward more recessionary outcomes. Fixed-income credit markets and recessions don’t go well together; elevated impairment and wider credit spreads are likely to result.  

Where are you finding opportunities to invest in the bond market? 

The current fixed-income backdrop faces challenges from both macro as well as idiosyncratic sector perspectives. That being stated, valuations appear to have priced in these uncertainties, and in certain cases, are possibly overcompensating investors for the risks. 

One area we find particularly attractive right now is higher-quality, high yield. We are observing a trend toward stronger fundamentals within the high-yield market, with management teams placing a heavy emphasis on balance sheet health and proactive refinancing of any near-term maturities. 

A positive byproduct of the rapid move higher in interest rates over the past 18 months is the significant increase in yield. 

Investors in higher-quality high yield can generally earn yields in the 7.5% to 8.5% area without having to take on significant duration risk. 

Furthermore, in the event that economic conditions begin to deteriorate, higher quality high yield should prove more resilient from a fundamental standpoint and experience more limited impairment and spread widening.  

Tom Graff, head of investments, Facet   

What are the biggest risks facing the bond market? 

At its core, the biggest risk is that interest rates continue to rise. There is really only one basic reason why general bond yields could rise from here, the Fed has to keep hiking because inflation remains out of control. As long as that doesn’t happen, longer-term bond yields will stay at or near where they are now. 

The reason is simple, longer-term bond yields reflect the market’s expectations for future Fed rate targets. In the last few weeks, longer interest rates have risen because the market believes the Fed will leave rates higher for longer. 

However, this has a natural limit to it. Eventually there is going to be a recession and therefore eventually the Fed will be cutting. For longer-term rates to exceed today’s Fed target rate implies that the Fed never cuts again. That just doesn’t make sense.   

Where are you finding opportunities to invest in the bond market? 

Our favorite corner of the bond market right now is intermediate-term, investment grade corporate bonds. For example, the Vanguard Intermediate e-Term Corporate ETF (VCIT). 

Right now, you are getting paid about 1.4% more in interest to own five- to 10-year corporate bonds versus similar maturity Treasury bonds. That makes for an all-in yield around 6.25%, and in a world where the economy seems to be growing nicely, that’s attractive on its own. 

But in addition, we think that the five- to 10-year part of the yield curve is the best segment to own right now. If the Fed is done hiking for this cycle, then the yield curve is likely to steepen from here. That means that either short-term interest rates will fall, because the Fed eventually cuts rates, or the market prices in "higher for longer" and very long-term rates suffer the most. 
We’ve seen this happening the last six weeks or so, where longer-term rates have risen much more than short-term rates. 

Stephen Tuckwood, director of investments, Modern Wealth Management 

What are the biggest risks facing the bond market? 

The biggest risk facing the bond market right now is the risk of stagflation. A stagflationary environment would be the worst of both worlds for the bond market, where inflation remains stubbornly high, and unemployment increases as economic growth stagnates. That would really box in the Fed into remaining higher for longer in the face of a declining economy and test their commitment to their dual mandate of price stability and maximum sustainable employment.    

Where are you finding opportunities to invest in the bond market? 

In our view, the spreads on corporate bonds, both investment grade and high yield are not fully compensating investors for the additional credit risk right now. Spreads are closer to average than the “pound-the-table" levels seen at various points of the last cycle, so we have a neutral view right now. 

Leveraged loans have been a bright spot this year, but in terms of credit, we like legacy or seasoned non-agency mortgage-backed securities as a component of a diversified portfolio. But in general, we think that locking in yields above 5% in short-term treasuries is a good spot to sit and be patient for better opportunities in credit to arise. 

Contact Jeff Benjamin at [email protected] and find him on X at @BenJiWriter