3 Reasons Not to Bet on Long-Term Bonds

A chorus of investment experts has recently been urging investors to plan ahead by shifting their excess cash balances to longer-duration bonds. While getting a 5% payout without taking on any risk is tempting, the thinking goes, the salad days for cash won’t last forever. I partially contributed to this narrative in my article, “Should You T-Bill and Chill?,” which concluded that holding cash isn’t a reliable way to build long-term wealth.

But there’s a danger of taking the anticash argument too far. Here, I’ll present three reasons to proceed with caution when venturing out on the yield curve. Note: My comments here primarily relate to bond funds, but the arguments mostly hold for individual bonds as well. The key difference is that if you buy an individual bond, you’ll earn the yield to maturity as of the purchase date and don’t need to worry about principal fluctuations as long as you hold the bond until maturity.

1. The Fed is in no hurry to cut interest rates. The conventional view holds that inflation will continue to moderate while the economy slows, prompting the Federal Reserve to start making rate cuts to prevent the economy from heading into a recession. Market observers are currently expecting at least two rate cuts later this year, with the highest probability for a rate cut in September.

This may or may not happen. The market has been overly optimistic on rate cuts before; at the end of 2023, for example, there was widespread market sentiment that the Federal Reserve would cut rates multiple times starting in early 2024.

The market might still be too sanguine on the size and speed of rate cuts. The Fed has a dual mandate to both promote maximum employment and stable prices (meaning avoiding long periods of high inflation). However, the economy remains relatively strong, which lessens the need for the Fed to cut rates to stimulate economic growth. At the same time, no one at the Fed wants to cut rates prematurely and run the risk of inflation heading back up. And as Pimco’s Jerome Schneider recently pointed out at Morningstar’s annual investment conference, Fed Chair Jerome Powell is probably especially mindful of this risk given that his term expires in 2026.

2. Even if the Fed does cut interest rates, payouts on the long end of the yield curve may not decline and could even increase. Interest rates on the short end of the yield curve typically move closely in line with changes in the federal-funds rate. But longer-term bonds, such as the 10-year Treasury, aren’t directly linked to changes in benchmark policy rates. Even with a decline in short-term rates, the long end of the yield curve could drift higher as the yield curve normalizes to reflect the more usual pattern of longer-maturity bonds offering a better payout.

Pressures related to funding the national debt could also push yields higher. The national debt now stands at nearly $35 trillion, which is close to an all-time high as a percentage of gross domestic product. To cover budget deficits, the US Treasury issues more Treasury securities, increasing the supply of bonds in the market. At the same time, investors often demand higher interest rates to compensate for a greater level of risk.

3. Shorter-term bonds are easier to use from a portfolio construction perspective. As William Bernstein has pointed out, it’s helpful to separate asset classes into two categories: risky assets that generate better returns and safe assets that have lower returns. Thus, muddying the waters by betting on price gains from longer-term bonds can be counterproductive.

Indeed, investors in long-term bond categories have often been tripped up by buying and selling at the wrong time. Morningstar’s long-term government-bond category, for example, attracted significant net inflows during 2021, right before the bond market’s historically painful drawdown in 2022. Because of this pattern, investor return gaps (the difference between what investors actually earn and the fund’s reported total returns) are much larger for long-term government-bond funds than for other bond-fund categories.

With short- and intermediate-term bond funds, on the other hand, investors are more likely to buy and hold, allowing them to keep a larger percentage of their funds’ returns.

Final Takeaways

Investors and journalists are carefully watching the Fed and parsing its statements to get a read on the timing and magnitude of potential interest-rate cuts. However, even investment experts and economists are notoriously bad at predicting interest-rate moves, making it best not to make dramatic portfolio changes based on their forecasts.