Bonds are (still) back

At the end 2022, an historically miserable year for fixed income, I wrote that bonds are back. I still feel that way. The Federated Hermes committee that sets duration exposure for our bond portfolios, namely the Duration Pod, has been bouncing between neutral to slightly long all year. That sounds like a cautious view, but it is a sharp departure from 2022 when we were short duration for most of the year amid a massive bond sell-off. Bond returns have been moderately positive year-to-date—the total return on the Bloomberg U.S. Treasury index is about +3.0%, partly driven by declining yields. After last year’s large losses and high volatility in fixed income, these returns and outperformance relative to cash represent a return to more “normal” behavior for high quality bonds.

Conditions favoring additional decline in Treasury yields are in place as we look forward; we have likely seen peak inflation, peak Fed tightening and peak growth. Add in the credit contraction that is likely to follow the recent banking turmoil and it is now more likely that recession will emerge later this year. With inflation still too high, consumer spending strong and the labor market tight, our current duration call represents only a slight lean long. However, each of these factors should ease in coming months as the cumulative impact of the Fed’s 500 basis points in rate hikes takes hold, generating opportunities to increase duration further. More immediately, event risk surrounding the debt ceiling may produce sufficient uncertainty and risk aversion to generate flight-to-quality demand for Treasuries.

In short, duration risk should no longer cast fear into the hearts of investors, but should rather be viewed as an opportunity within diversified portfolios.