Investors have been willing to absorb strong issuance of quality bonds from companies. (UBS)

The move in Treasuries partly reflects increasing caution among investors over how soon the Federal Reserve will start cutting rates. The futures markets are now implying a 50%chance of a cut at the Fed's March policy meeting, down from over 80% at the start of the year.


But we don't expect the recent weakness in quality bonds to last, and highly-rated bonds remain our most preferred asset class:


A decline in real rate expectations should drive the next leg lower in yields. While the near-term movement of policy rates has attracted a lot of investor attention, we think the end point for rates is also important. The median estimate of Fed officials for the longer-term policy rate is 2.5%, or 0.5% in real, post-inflation terms. With the current market-implied long-term real policy rate still above the Fed’s estimate, we think the next leg lower in yields is likely to be led by lower long-term real rates. One driver is likely to be a tapering of the Fed’s bond-selling program (quantitative tightening), which would reduce upward pressure on real rates. The latest FOMC minutes showed that Fed officials were already discussing when to reduce the pace of sales.


The appeal of bonds over cash has become clear. The past two years have offered investors the opportunity to earn attractive returns in cash and money market funds. But with inflation falling and interest rate cuts on the horizon, the reinvestment risk of holding too much cash has become apparent. Historically, it has paid to be proactive and switch from cash to bonds well ahead of the first interest rate cut, as cash underperforms in the later stages of rate-hiking cycles and during rate-cutting cycles. In our base case, we expect 8.5% returns for high-quality, medium-duration bonds this year, versus 4.3% for cash (in USD terms).


Investors have been willing to absorb strong issuance of quality bonds from companies. US businesses issued USD 153bn worth of investment grade bonds in the first three weeks of January, the busiest opening to the year for dollar-denominated debt since records began in 1990, according to a FT report. The large supply of bonds has been met by high investor demand, with the spread over US Treasuries paid by corporate borrowers shrinking to the lowest level in two years. Overall, we think all-in yields on offer remain attractive. We also see the potential for capital appreciation amid slower economic growth.


So, even though yield volatility is likely to remain elevated in the near term, we continue to favor quality bonds in our positioning. In a hard-landing scenario, we would expect double-digit returns for the segment. Even in a Goldilocks scenario, which is the least favorable for quality fixed income, returns are still likely to be positive.


Main contributor - Solita Marcelli, Mark Haefele, Daisy Tseng, Frederick Mellors, Christopher Swann, Jon Gordon, Jennifer Stahmer


Original report - Bonds remain appealing amid equity rallies, 24 January 2024.