Why Bonds Seem More Attractive Than They’ve Been in a While

Bond investors enjoyed a long and prosperous 40-year run before post-pandemic inflation crashed the party. Ironically, the same thing that spoiled the last bond-market bash—high bond yields—may help start a new one.

Not only can investors cash in on current high bond yields, but they may also stand to gain from rising bond prices once the Federal Reserve moves to cut its benchmark interest rate. Bond values typically move in the opposite direction of bond yields.

That could make bonds appealing to investors, especially as stocks hover near all-time highs.

Make The Most Of Higher Bond Yields

“It’s a much better time to invest in bonds than a few years ago,” said Kevin Lum, a certified financial planner and founder of Foundry Financial, adding that “bond yields are much more attractive.”

The 10-year Treasury yield briefly crossed 5% last October for the first time since 2007, and it has remained stubbornly higher than 4% since mid-January. That’s much higher than the near-2% yields on the 10-year note when the Fed began raising rates in March 2022.

Rising yields—courtesy of the Fed’s two-year rate-hike campaign designed to cool the economy and tame inflation—helped produce the most extensive bond market losses in history.

But now that interest-rate cuts from the Fed seem possible this year, current yields should cause investors to seriously consider bonds, market watchers say. High yields are not just beneficial in the short-term, they may also be a proxy for future returns.

“Starting yields are highly correlated with five-year forward returns,” analysts at PIMCO said in recent commentary.

Bonds in Good Spot No Matter What Fed Does

Regardless of what the Fed does with respect to interest rates, bond investors could be in a sweet spot. Here’s why:

If the Fed cuts rates, bond yields should drop. That would boost the value of existing bonds with higher coupons, or yields, versus new bonds that would get issued with lower yields. 

If the Fed doesn’t cut rates, leaving bond valuations relatively flat (depending on other market variables), the current yield on the 10-year note still would provide guaranteed annual income of around 4.5%.

According to PIMCO analysts, fixed income bets such as bonds are “positioned to perform well if there are no recessions over our secular horizon and to perform even better if there are, with the potential for price appreciation if yields decline, which makes bonds attractive.”

Financial markets are pricing in the likelihood the Fed will cut its benchmark rate once or twice before the end of 2024, and see almost no possibility the central bank will have to raise rates again. Simply put, bond yields are unlikely to rise significantly going forward, but they’re also unlikely to fall significantly.

Bonds May Have An Edge Over Stocks Right Now

Investors long have compared a bond’s coupon with a stock’s earnings yield when deciding between those two assets. In that comparison, bonds are looking good.

The 10-year note’s yield at the end of May was not only higher than the S&P 500’s dividend yield but also higher than the index’s earnings yield of 3.96%. The S&P 500’s earnings yield has dropped from its 4%-plus average over the 5-year and 10-year periods as of May 31, according to Factset data.

As stocks have hit record highs repeatedly in recent months, valuations have pushed the index’s price-to-earnings ratio to 25.2, considerably higher than its five-year average of 23.3. In short, the ongoing rally in stocks and the two-year downturn in bonds has made the former look expensive compared with the latter.

“Steady economic and earnings growth this year has kept the risk-reward trade-off for stocks and bonds fairly well balanced, but moving forward, with valuations for stocks elevated and bonds offering more attractive yields, we believe bonds hold a slight edge over stocks,” wrote LPL Financial’s, chief technical strategist Adam Turnquist and chief equity strategist Jeffrey Buchbinder in recent commentary.

Bonds are also considered less risky compared to stocks.

“We see the potential for better risk-adjusted returns for bonds than stocks,” said Vanguard in a May report, adding that it expects “a 50% chance that U.S. aggregate bonds will return about as much over the next five years as U.S. equities— 4.3% for bonds versus 4.5% for stocks—with one-third of the median volatility.”

Bond investments aren’t completely devoid of risks either. Trying to time the bond markets could prove to be challenging just like with the stock markets. There is still a fair bit of uncertainty around the Fed’s next move on rates.

“Investors should be cautious about chasing higher yields, as it often involves taking on stock-like risk, without the same upside,” said Financial Foundry’s Lum, who suggests investors consider their overall investment strategy and liquidity requirements before deciding on what kinds of bonds they invest in.