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Things are looking up for bond markets. As yields rise, the potential for income is the highest in more than two decades, and volatility tied to interest rate increases may decline as the US Federal Reserve (Fed) nears the end of its rate-hiking campaign. Through it all, the US economy has surprised to the upside.

In an ideal world, achieving high income against this backdrop would be as easy as parking cash in relatively low-risk money market funds and hoping it grows. The reality is more nuanced: Rates are likely to fall from here, so it’s unrealistic to expect returns from cash and cash-like investments to stay at current levels long term.

In fact, the return potential for the record $5.5 trillion sitting in money market funds will likely decline as inflation falls and the Fed concludes its rate increases. The jury is out on just how quickly or when exactly rates will fall, but bonds have historically seen returns above cash and cash-like investments in the years following a peak in the Fed funds rate.

Although the outlook is rosier, the economy is not out of the woods as rate increases continue to impose much higher borrowing costs on companies and consumers.

Against this backdrop, fixed income portfolio managers Damien McCann and David Daigle offer their thoughts on compelling investment opportunities as the economy and the Fed near a pivotal phase.

1. Seek to capture attractive yields before rates fall

Yields soared and bond prices tumbled in 2022 as elevated and persistent inflation pushed the Fed to raise rates at a breakneck pace. So far in 2023, volatility hasn’t been nearly as dramatic, but stubborn inflation has pressured the central bank to continue with more gradual rate increases.

More recently, the yield on the 10-year Treasury, which underpins borrowing costs for much of the US economy, hit 4.35% in August, the highest level since 2007. And while the month-long volatility has been tough on bond markets, elevated long-term rates should ultimately dampen inflationary pressures.

Despite lingering uncertainties about the economy, one thing is clear: The rise in rates created many paths to strong income and return potential in bond markets. 

That’s because starting yields have been a good indicator of long-term return expectations. The Bloomberg US Aggregate Index, a widely used benchmark for investment-grade bonds (rated BBB/Baa and above), yielded 4.93% as of 25 August, 2023. That figure is well above the index’s yield of 1.70% on 31 December, 2021, prior to the start of the Fed hiking cycle. The Bloomberg US Corporate High Yield Index, a broad representation of high-yield bonds, yielded 8.48% as of 25 August, 2023, versus its yield of 4.41% on 31 December, 2021.

“Getting here has been painful, but bonds now offer fantastic income potential,” McCann says. A strategic allocation to higher income sectors can help boost long-term return potential, with lower volatility than equities, which is an important consideration for income-seeking investors. Higher income seeking sectors include corporate investment-grade and high-yield bonds, emerging markets debt and securitised debt.

“If inflation continues to ease and economic growth remains sluggish, rates will likely decline somewhat from here, while remaining higher than investors have become accustomed to in recent years,” McCann notes. In that context, fixed income sectors may be attractive since bond prices rise when yields fall. And since the total return of a bond fund consists of income and price changes, “falling yields would be a tailwind for returns on top of the hefty coupon payments from bonds,” he adds.

The surest path to falling yields — and potential price appreciation — is via rate cuts by the Fed. That could happen if inflation continues to fall, the economy enters a significant downturn, or central banks seek a “neutral” policy rate that neither restricts nor stimulates economic growth, according to Daigle. Falling Treasury yields would help offset the negative impact of wider credit spreads, or the incremental yields that bonds typically pay over Treasuries.

2. Consider investment-grade bonds while fundamentals are strong

The recession that was supposed to be here by now appears to be on hold. To be sure, there are weaknesses in various parts of the economy but even areas sensitive to rising rates, such as housing, may be stabilising.  

“Consumers continue to power the US economy,” McCann says, “and while there has been some softening, trends remain encouraging with firm labor markets and steady consumer spending for leisure and travel activities.”

Delinquencies for credit cards edged higher in the second quarter compared to the first three months of the year, but are not worse than pre-pandemic normalised levels, according to an August 2023 report from the Federal Reserve Bank of New York.

Many companies have been able to pass on costs to consumers, which has bolstered corporate fundamentals, including profits. These companies have also worked to reduce operating expenses and are managing their cash conservatively.

“That strategy should allow these companies to continue to refinance or repay their debt as earnings growth slows or contracts in a downturn,” McCann says.

More opportunities are emerging across industries in investment-grade bonds. One area of potential value is large money center banks, where spreads are well above historic averages and the credit quality is excellent. “Recent troubles in the banking sector seem to be contained, and while banks overall have dialed back on lending, the contraction hasn’t yet been severe enough to push the economy into a recession,” McCann adds.

3. Look to high-yield bonds where stars appear aligned

For investors with a time horizon of at least a year, some risks may appear worth taking. 

So far this year, starting yields of around 8% have provided a buffer against bond market volatility tied to the Fed’s rate path. That in turn has helped support solid returns for the year-to-date period ended 29 August, 2023, with the Bloomberg US Corporate High Yield Index posting a 6.81% gain.

“Many companies in the high-yield market have adapted fairly easily to higher rates,” Daigle says. For example, several companies have paid down debt, thereby reducing interest expense. Lower leverage and improved operations have increased the number of “rising stars,” or companies that have been upgraded out of high-yield territory. According to Daigle, that trend is likely to continue.

One challenge ahead is the potential consequence of high borrowing costs on companies. At some point, higher rates may lead to weaker credit profiles and lower valuations. “This process could be gradual rather than abrupt and investing in high-yield bonds today may help offset future volatility associated with a slowdown,” Daigle says.

Any issuer facing a combination of higher funding costs and deteriorating earnings will likely have a difficult time refinancing its debt, underscoring the importance of a selective investment strategy. “This is not really an industry-level phenomenon,” Daigle concludes, “although there are issuers within the communications sector that appear particularly exposed.”

4. Diversify your income investments

A common investment strategy applies, even when rates are this elevated: diversify your holdings.

For income-seeking investors, this includes investing across bond sectors that have been hard hit, such as emerging markets and securitised debt. Returns across investment grade, high yield, emerging markets and securitised debt vary over time. McCann believes a diversified, multi-sector approach can help investors navigate headwinds that impact parts of the economy unevenly.

Several countries are having a tough time in this high interest rate, slow growth environment, but the net is wide in emerging markets and many issuers have been able to navigate these circumstances, according to McCann. For example, Oman has benefited from higher oil prices. Additionally, Latin American countries proactively lifted rates well before major central banks, which helped insulate economies by easing inflation and currency pressures.

As markets continue to react to Fed moves, inflation and shifting narratives about the economy, investors should focus on long-term financial goals.

“You can’t predict the future, so I always advocate for both a multi-sector approach and a long-term perspective,” McCann concludes. “I’m optimistic as rate hikes have set the stage for much stronger income and return from bonds in the years ahead.”