Over the last two years, the bond market hasn’t provided the defensive features that investors love. New, higher interest rates present an opportunity in the 2024 fixed-income outlook.
For the first time in decades, we’re observing positive expected real yields. Interest rates have increased from practically zero across the developed world—even negative in some cases. Bond yields have anticipated these rises and increased too, with 4-5% yields generally available across the curve.
This shift has upended the investing landscape as we knew it. Interest rate hikes affect stocks, bonds, property, and cash, earning from consideration from all investors. But it’s not just about chasing yield in different asset classes. Advisors must help their clients consider credit risk and dividend stability to stay on track with their investing goals.
If you’re a financial advisor, download the report here. If you’re an investor, please visit morningstar.com or consult your financial advisor.
More Treasury Bonds in the Market Could Affect Demand
The U.S. Department of the Treasury faces a maturity wall. It expects to borrow more than $800 billion in the first quarter of 2024. Increased supply could test investor appetite and drive down bond prices. If interest rates remain high, the government may have to refinance at steeper rates, which would result in higher yields.
Action Steps for Financial Advisors
Review fixed-income portfolios for opportunities. How have they performed against peers in the category? What part of the yield curve are your clients capturing? What is the balance of government and corporate bonds?
Worsening Company Fundamentals Could Affect Corporate Bonds
Worsening company fundamentals can affect the risk of default in corporate bonds, whether investment grade or high yield. If a company goes bankrupt, clients won’t receive the income they expect. Financial advisors should watch for:
- Declining revenue and earnings growth.
- Higher leverage ratios, although they remain well within historical norms.
- Lower interest coverage, which signals companies may struggle to make repayments.
High-yield bonds show early signs of strain, although from a historically low base. However, Morningstar expects that high-yield bond issuance won’t materially increase in 2024. Most of the high-yield debt will mature in the 2026 to 2029 window. The credit quality of high-yield bonds has also improved, which could better position them than in prior periods.
Action Steps for Financial Advisors
Watch the credit spreads between corporate and government bonds. Spreads are one indicator of economic health, and often shrink when investors are more confident in the economy. Heading into 2024, these spreads look narrow, which decreases the appeal of corporate bonds over their Treasury counterparts.
High absolute yields may be attractive, but they come with inherent risks. Investors should weigh high returns against a potential default cycle, which spreads do not reflect.
Advisors can monitor the default risk of corporate bonds with the Morningstar Fixed-Income Style Box. The visual summarizes a fund’s underlying holdings, showing aggregate credit quality and interest-rate sensitivity. It can help clients understand the strategy behind their portfolio.
Higher Inflation Could Shake Up the Bond Market
While Morningstar economists don’t predict higher inflation as our base case, it could still increase in 2024. Central banks often try to reduce inflationary pressure by raising interest rates, which can reduce consumer consumption and raise production costs. This often as a negative impact on corporate earnings and economic growth.
Combined, those impacts could worsen fixed-income volatility and create a challenging environment for investors.
Action Steps for Financial Advisors
Cautious investors may be interested in ways to offset the risk of higher inflation. Inflation-linked bonds could be a relatively cheap insurance option at current breakeven levels. These bonds adjust their principal value and interest payments based on changes to the inflation rate.
While short-dated bonds may appeal to conservative investors, advisors also need to consider reinvestment risk. Short-dated bonds today offer high yields that might not be available if rates are cut.
See more of Morningstar’s best investment ideas.
High Volatility Shapes Our Bond-Market Outlook
The major uptick in volatility, especially in long-term bonds, could affect investor behavior. After a lifetime of focus on portfolio growth, retirees feel hesitant about drawing down their savings. Swings in portfolio value could trigger knee-jerk reactions out of an impulse to preserve their nest egg.
Action Steps for Financial Advisors
With a structured, goals-based approach to investing, advisors can help clients stick to the long-term plan. Beneath common financial goals lie deeper motivators, like spending quality time with family or giving to charity. When advisors understand these life goals, they can help clients build realistic plans and dodge behavioral pitfalls.
Educate clients about the current state of the bond market and what volatility means for their portfolios. Webinars, blog posts, and white-labeled research reports can expand the reach of your expertise.
A Continued Duration Rally Could Hit Short-Dated Bonds
Plummeting interest rates, perhaps in a deep recession, could negatively affect the relative performance of short-dated bonds. This creates reinvestment risk, or the risk that a bond matures after rates fall and investors need to reinvest the proceeds at lower rates.
Action Steps for Financial Advisors
Keep an eye on the inverted U.S. Treasury yield curve. Curves don’t typically stay inverted for long—it’s unusual for long-term bonds to have smaller yields than their shorter-term counterparts. If interest rates and stock prices fall, advisors may be able to protect against a recession by tweaking bond allocations.
While dividends remain a key area to explore, instability could pose a risk to income investors. Sectors such as energy and financials are more prone to dividend cuts during downturns.
Turning Risks Into Opportunities
In the world of income-producing assets, the noteworthy shift in base rates has affected the investment case. Navigating this shift can yield fruitful results if we understand how to use the fluctuations to our advantage.
For more of Morningstar Investment Management’s best investing ideas, download the 2024 fixed-income outlook.
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