Investing in bonds is cool?!

By David DeBellis, CFA & Portfolio Manager

As a dyed-in-the-wool “stock guy,” it pains me to admit it, but bonds are no longer the ugly duckling of the asset classes where you invest for safety, expecting relatively low returns. For the ten-year period ending in 2022, the 10-Year Treasury Bond returned less than 1% annually. 2022 was a particularly tumultuous year in which many bond indexes posted double-digit losses.

However, the bond market got off to a strong start in the new year. Bond yields came down sharply as softening inflation data gave way to talk that the Fed would soon be done with raising rates. But the Federal Reserve responded with tough talk on inflation, and reiterated their goal to bring inflation back to 2%. This has caused longer-term rates to rise again to near their highs of last year.

There is still a lot of uncertainty ahead, but bonds now offer the kind of return potential not seen since long before any of us ever heard of Quantitative Easing or Zero Interest Rate Policies. In fact, bond returns tend to be quite strong after down years. Since 1976, in the years following bond market declines, the average return has been 11.5% (as measured by the Bloomberg U.S. Aggregate bond index). At the same time, the shape of the yield curve is signaling caution ahead.

The Treasury Yield curve, shown below, neatly summarizes the opportunities and the risks alike. Since I’m a positive person by nature, we’ll start with the opportunities. In February of 2021, every Treasury maturity up to seven years yielded less than 1%. In February of 2022, the 1-Year Treasury was yielding slightly more than the 7-Year Treasury Note a year earlier, but shorter-term bonds were still yielding very close to zero.

Bonds now offer the kind of return potential not seen since long before any of us ever heard of Quantitative Easing or Zero Interest Rate Policies.

Today, an investment in a 3-Month Treasury Bill gets you a 4.86 percent yield, and you can park funds in a 1-Year Treasury Bill for just over 5 percent!

As inflation is still running north of 6%, the real (adjusted for inflation) yield on Treasuries is still negative. However, if the Federal Reserve continues to be successful bringing inflation down then locking in these rates could provide investors with an excellent total return opportunity for the future.

Yields on Treasury Notes are finally as high as, or higher than, those provided by stocks or other higher-risk investments. This could have an adverse effect on these higher-risk securities as investors opt for the less risky alternative for generating cash flow from their portfolios.

The chart above also shows the potential risks ahead. As you can see, the yield curve is inverted all the way from the shortest maturity to the longest maturity, with the 1-Month Treasury Bill yielding 4.68% and the 30-Year Treasury Note yielding 3.93%.

This rings alarm bells, because an inverted yield curve has historically been one of the most reliable indicators of an approaching recession. As of the end of January, the consensus among economists for a recession in the next 12 months was 65%, down from almost 100% last October. But some, like Goldman Sachs, put those odds closer to 25%, saying that strength in the labor market and signs of improvement in the business surveys suggest that the risk of a near-term slump has diminished significantly.

Regardless of what the economists are saying (remember that economists have predicted 10 of the last 8 recessions…), the yield curve says we should expect a recession sooner or later. So, what could that mean for the kind of assets you want in your fixed income portfolio in the year ahead?

One key assumption associated with a recession is that risk spreads typically would widen from where they are today. A widening of credit spreads would mean that the riskier bonds would underperform high quality ones. For this reason, Trust Company of Vermont has focused client bond purchases in U.S. Treasury securities and high-quality municipal bonds.

Last year, elevated volatility led valuations to reset across the capital markets. As the dust settles, bonds are looking outright cheap relative to the past 20 years, with valuations in U.S. Treasuries well below their long-run average. Reiterating what I stated above, we feel this is a very attractive entry point for investors, and if the Fed is successful in their mission to bring down inflation, it could be some time before we see yields like this again.