This One Tweak Could Improve Your Bond Portfolio in Q2

Susan Dziubinski: And then pivoting over to bonds, how should investors be thinking about the duration of their fixed-income positions heading into the second quarter given Morningstar’s outlook for interest rates?

David Sekera: The bond market has continued to struggle thus far this year. So, the Morningstar US Core Bond Index—and, again, that’s our proxy for the full overall fixed-income market—that’s down a little bit under 1% year to date. Essentially what’s happened here is that we have seen long-term bond interest rates rise.

And, of course, as interest rates go up, that pushes the bond prices down, and that more than offset that underlying yield carry that you generate on bonds. But based on our interest-rate forecast, I do think investors are still best served in what I call longer-duration bonds. That five- to seven-year, even out to that 10-year duration, I think looks pretty attractive.

I think at this point you can lock in kind of the currently higher interest rates that we see. When I look at the yield curve, we do project in the short term that the federal-funds rate yield will fall over the course of the second half of this year, getting down to 4.00% to 4.25% by the end of the year.

But we expect that to fall even further next year in 2025, getting down to a 2.50% to 2.75% range. So, you are getting very high yields today in the short term, but I do think that those yields will start going down over time. Now, in the longer end of the curve, our economics team does project that the yield on the US Treasury of the 10-year will average 4% this year, so that does mean that will be going down in the second half of this year. But then the US economic team does look for that still to fall further in 2025, averaging 3% next year.

Dziubinski: Dave, within fixed income, what’s your take today on government bonds versus high-quality corporate bonds versus junk bonds?

Sekera: Well, at this point, I think investors are going to be better served overweighting US Treasuries in that fixed-income portion of their portfolio. Again, our base case is still looking for that soft landing for the economy. But when I look at the corporate bond market, I would say credit spreads there have tightened to the point where I no longer think you’re really getting adequately compensated for the added risk of defaults and downgrades.

When we ran our numbers for this most recent outlook, the average credit spread of the Morningstar US Corporate Bond Index, which is our proxy for investment-grade bonds, was only 86 basis points over Treasuries. And then the high-yield index, that average spread was only a little over 300 basis points. So, a lot of people may not understand what that means. By way of comparison, I would just say that at the beginning of this year in our 2024 outlook, we had moved to a market weight in corporate bonds. The investment-grade spread at that point was 98 basis points and the high yield spread was 338. And at the end of 2022, when we had recommended an overweight in corporate bonds, the average spread for investment-grade was 130, and the average spread for high yield was 457.

When I look at corporate bonds and I look at credit spreads since 2000, so over the past 24 years, when I look at how credit spreads and how tight they are today compared to that time frame, I think only 2% to 3% of the time have credit spreads traded at tighter levels than what we see today.

This is an excerpt from the April 1, 2024, episode of The Morning Filter. Watch the full episode, 5 Undervalued Stocks to Buy During Q2 2024. See a list of previous episodes here.