It’s rare that Wall Street gets excited about bonds, but after last week’s wink and nod from Federal Reserve Chairman Jerome Powell that the “pause” on rates might also mean the Fed is done for this cycle, all classes of bonds ripped higher in reaction. Calls from trading desks around the world to “lock in rates” were resonating all of last week.
The combination of last Monday’s Treasury issuance of the less-than-forecast $776 billion for the current quarter, followed by the schedule of shorter maturities that would meet better demand, followed by a dovish Fed policy statement, topped off by Friday’s weaker employment data, provided even more fuel.
The yield on the two-year Treasury moved from 5.08 percent on Monday to 4.84 percent at Friday’s close—a shift of 24 basis points. In a more dramatic event, the 10-year Treasury note yield fell from 5.00 percent to 4.48 percent, before settling at 4.55 percent for the week—a 45 basis-point drop—one of the more significant Treasury yield moves in recent memory, providing momentum into the weekend that was certainly the main catalyst for the stock rally.
The bond market is the default mechanism for investors who care about preservation of capital as their number-one priority. However, with U.S. fiscal policy in the “drunken sailor” school of economics, it stands to reason that yields on the long end of the curve will remain elevated due to long-term risks associated with a soaring federal budget deficit. In my view, that ship is on its own course, and with no political will to rein in spending, it doesn’t look good to place your bets on America’s fiscal future going out 20–30 years.
With China and Japan dumping U.S. Treasurys, and the U.S. Treasury Department now issuing trillions of dollars in fresh paper, the pressure on maturities of 10 years or further out could remain under suspicion, whereas the short end of the curve starts to anticipate rate cuts by the Fed beginning in mid-2024, at the latest.
As of last Friday, the CME FedWatch Tool showed a nearly 50 percent chance of a quarter-point rate cut at the May 2024 meeting of the Fed’s policy-making Federal Open Market Committee (FOMC). If the softer jobs data begin a trend of weaker labor numbers going forward, then this forecast looks pretty good, and investors should want to be in front of this by a good six months.
Buttressing the CME FedWatch Tool forecast is the sharp decline in fourth-quarter GDP estimate by the Federal Reserve Bank of Atlanta’s GDPNow estimate, showing the U.S. economy growing at just a 1.2 percent rate, down from 4.9 percent last quarter. Some economists are even calling for negative growth. This report raised a lot of eyebrows across the investment community last week, because it implies a fairly dramatic slowdown in consumer spending for the holiday-shopping season, coupled with lower business investment by year’s end.
With these parameters as a backdrop, buying investment-grade corporate bonds with maturities of two to four years looks to be an attractive investment proposition for a number of reasons.
1. If the Fed is going to start cutting rates by the middle of next year, rolling six-month to one-year Treasurys will be done so at lower rates than where they trade today—which is probably why billionaire hedge fund manager Stanley Druckenmiller bought a huge position of two-year Treasuries, expecting the yield curve to normalize with the two-year rate dropping to 3 percent in a couple of years.
2. While a laddered two-, three-, and five-year Treasury portfolio is paying a blended yield of 4.66 percent, a laddered two-, three-, and four-year investment-grade corporate bond portfolio is paying 5.83 percent, a full 117 basis points higher, but with one caveat. Treasurys are issued at par every week, so investors are receiving the full average 4.6 percent interest income. Most corporate bonds in the range of two to four years are trading at discounts to par since they were issued when rates were lower. Hence, the average distribution rate is about 3.8 percent, but the yield to maturity (total return) is around 5.83 percent as there could be capital appreciation, too.
3. If, in fact, Washington can’t agree on debt reduction, then the risk of a government shutdown and failed bond auctions rises. If there is another regional banking crisis due to holding too many low-yielding Treasurys, too much corporate office debt, too much money leaving for higher money market yields, then certificates of deposit (CDs) are at risk of being “money good” when they mature. Get in line at the Federal Deposit Insurance Corp. (FDIC).
4. Conversely, with high-grade corporate debt now pushing 6 percent on a total return basis for two to four years, why not have money on deposit in the best-fortressed balance sheet companies in the world?
Bonds of the top blue-chip companies on the benchmark S&P 500 Index cannot be easily purchased by individual investors. Institutional money gobbles them up the instant they become available, but there are some exchange-traded funds (ETFs) that provide for buying baskets of these bonds that pay monthly. While there is no guarantee the bond yields might not rise further, at least the risk of short duration for maturities is well defined, and something close to 6 percent for 24- to 48-month corporate debt that is as near to bullet proof just might make perfect sense.
