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The path to higher interest rates is painful, but it should ultimately benefit bond investors over the long haul.

The US Federal Reserve (Fed) raised its benchmark policy rate by 0.75% to 1.50%–1.75% in June, the biggest increase since 1994. The central bank also signalled an additional 1.75% of increases ahead. Policymakers specifically raised the median year-end projection for the Fed funds rate to a range between 3.25% and 3.50%.

US bonds have tumbled more than 10% so far this year, but there are signs the worst may be over. Investors have several reasons to own bonds as the Fed attempts to steer the economy toward a much-debated soft landing.

1. Big declines may bring opportunities

Bond investors have snapped up debt as prices declined sharply on fears the Fed’s effort to tame inflation could severely strain economic growth. The buying spree helped most bond sectors post positive returns in May.

Questions that drove volatility remain, but now may be an opportune time to turn anxiety into action. “Equity market swings will likely continue, but bond markets are unlikely to decline another 10% from here,” says portfolio manager, Ritchie Tuazon.

The downward selling pressure has brought valuations for most bonds back to Earth and more in line with expectations. This may provide an attractive entry point for investors.

Exposure to high-quality bond funds can again offer the diversification investors want, especially amid heightened equity volatility. Investors can also seek opportunities across bond sectors to achieve investment goals such as income and inflation protection.

2. Current bond yields largely account for inflation-driven rate hikes

The Fed’s rate hikes and balance sheet reductions suggest a focus on bringing down inflation. But there is still work to do.

The US consumer price index jumped 8.6% for the year through May and is up 1% from April. Core inflation, which excludes food and energy, rose 0.6% from the prior month.

The overall number is worrisome. “I think the Fed is still behind the curve on rate hikes,” Tuazon adds.

Prices likely peaked for some items that surged in demand during COVID lockdowns. Case in point: Lumber prices jumped alongside home sales and renovations during the pandemic but have slid 50% from the start of the year. However, prices for services and necessities such as food, housing and energy have skyrocketed. “It may be a case of one replacing the other, keeping inflation high,” Tuazon notes.

Persistent inflation may force the Fed to revise its rates path higher. However, since investors have mostly priced bonds to account for the more aggressive plan, future adjustments are unlikely to result in as much bond market turmoil.

Over the next year, bond yields are less likely to climb as much as they have since July 2021, when markets began to worry about elevated inflation.

3. Income is back in fixed income

Investors may soon be able to cash in on higher rates.

Yields on bonds have risen sharply since the lows experienced in recent years. Yields, which rise when bond prices fall, have jumped across bond sectors. Over time, rising yields mean more income from bonds.

There are still pitfalls ahead, so an active approach might help. While a US recession does not appear imminent, credit spreads may widen as investors forecast the likelihood of one, says portfolio manager, Tara Torrens.

Certain industries that are defensive in nature, such as health care and food, may offer more value in this environment. Commodities companies can also offer refuge in a late-cycle period. “There are always opportunities, but I’m maintaining a lot of liquidity that could then be redeployed if we see the type of spread widening that I’m expecting,” Torrens says.

Emerging markets debt — a corner of the bond market that has been especially volatile — offers some opportunities as well. Several countries have raised rates ahead of the Fed and are on good financial footing, according to portfolio manager Rob Neithart. Given the nuances of emerging markets investing, an active approach can help steer investors toward select investment ideas.

Current yields have delivered attractive returns

At today’s yields, history suggests higher total returns over the next few years. This means that investors could benefit from holding bonds across fixed income asset classes, including high yield. 

“Average annual returns for the US high-yield market historically are approximately 6% to 8%. We are again at a starting yield level where these returns could be achieved, with a multi-year investment horizon, which is the first time this has been true in a while,” Torrens says.

Why own bonds now?

Investors have a lot to be pessimistic about: war in Ukraine, inflation and fears of a looming recession. Big declines occurred as investors feared the Fed could crimp growth as it raises rates and ends its asset purchases.

Although risks remain, bond investors have largely priced in rate hikes. Now could be an attractive entry point, particularly for those using bonds to buffer equity volatility.

“There’s a lot to be positive about despite all the negative headlines,” Tuazon says. “While past results are no guarantee of future outcomes, a long-term perspective can help investors recognise that yields at current levels have historically delivered more income and attractive returns.”