What to Know About Bond Investing Ahead of 2024 – Morningstar

Susan Dziubinski: Before we look ahead, let’s take a look back over 2023. How’d the overall bond market do?

Dave Sekera: After the worst year in history in bonds last year, fixed income did bounce back a bit and is in positive territory this year. For example, if I look at the Morningstar Core Bond Index, and that’s really our proxy for the overall broad market, through Dec. 5, that was up 2.77%. I would note that the return is still depressed this year. We did see some price depreciation as interest rates did rise, and that offset some of the yield that otherwise investors would’ve earned.

Dziubinski: What parts of the bond market performed the best in 2023?

Sekera: Bonds that trade with a credit spread over Treasuries performed the best thus far this year. For those of you not that familiar with what credit spread is, that’s additional compensation that you receive as an investor over maturities with comparable U.S. Treasuries. That compensates for the added risk of different types of bonds that have credit risk of downgrades or defaults. For example, in the asset-backed securities market, also known as ABS, those rose a little bit over 5%. But the biggest winners this year were corporate bonds. The Morningstar Corporate Bond Index, our proxy for investment-grade corporate bonds, is up almost 5.5%. In the junk-bond market, the Morningstar High Yield Index was up over 10%.

Dziubinski: What does the yield curve look like as 2023 is winding down?

Sekera: Well, taking a look at the yield curve, it’s more inverted now than it was at the end of last year. That’s really just because the Fed did hike the federal-funds rate pretty substantially over the first half of 2023. If I look at the very shortest end of the curve, one-month T-bills rose 140 basis points. That was really in relation to the Fed. I think they hiked about 100 basis points at that point in time. Then on the longer end of the curve, the yield on the 10-year rose, but it only rose 30 basis points, getting up to 4.18% as of Dec. 5.

Dziubinski: We’re heading into 2024 with higher interest rates than we had coming into 2023, but we have seen yields on the 10-year Treasury drop over the past few weeks after peaking at around 5%. What’s Morningstar’s forecast for both short-term and long-term rates in 2024?

Sekera: For 2024, we do forecast both short-term and long-term rates will be coming down. Our current forecast in the short term is that the Fed will start cutting the federal-funds rate. We expect that to get down to a range of 3.75% to 4.00% by the end of the year. In fact, we expect that to continue to keep coming down in 2025, getting down to 2.25%. On the longer end of the curve, our forecast is for the 10-year to average 3.60% over the course of 2024, also remaining on a downward trend going into 2025 and averaging about 2.75% in 2025.

Dziubinski: Then given your expectations, Dave, what parts of the bond market would you expect to do the best in 2024?

Sekera: Based on that interest-rate forecast, I do think long-term bonds should perform the best in 2024. Right now, it does look like a better return in the short term because you are getting that higher yield, but you get very little price appreciation over time with short-term bonds. Plus, when you buy those short-term bonds, you’re subject to whatever the prevailing interest rates are when it matures, when you need to then reinvest those proceeds. Considering you do expect short-term rates to fall, you get that higher yield for a little while. Whether that’s six months, one year, two years, but as those short-term rates fall, you’ll get a total return lower when those rates fall over that same time period.

Now, long-term rates are slightly lower right now, but you get the added duration effect of those long-term rates. What that means is that long-term bond prices will increase the further out on the yield curve you go as those yields drop. While you’re getting those lower yields, you’re locking in what’s going to be higher yields now as compared to where they’re going to be in the future. What happens is investors are willing to pay higher prices for those bonds with those higher coupons. If yields do move as we forecast, we expect you’ll get total returns that are going to be higher in those long-term bonds based on the combination of not only the yield that you’re getting but also that price appreciation.

Dziubinski: Wrap up bonds for us, Dave. How should bond investors be thinking about their fixed-income investments today?

Sekera: Well, in our midyear bond outlook, I believe that was in maybe July that we published that, we advocated that investors should begin to move into bonds with longer-term maturities. We still hold that view today. Based on our economic outlook and our interest-rate forecast, we do think that those long-term bonds are the most attractive part of the curve. Just to put it in context—again, this isn’t a forecast and this is just a back-of-the-envelope estimate made—but if rates do play out as our economics team forecast, we think you could see total returns and long-term bonds over the course of next year appreciating as much as 8% to 9%. Half of that is going to be the amount that you would earn on the yield, and the other half would be from price appreciation. Then switching gears a little bit, taking a look at the corporate-bond market, I’m actually not as excited about corporate bonds right now as I was in our 2023 outlook.

Corporate credit spreads have tightened to levels that I think while they’re still adequate based on our economic outlook and our interest-rate forecast, they’re by no means cheap anymore. My concern here is that as the rate of economic growth slows over the next couple of quarters, that could generate some negative sentiment in the markets. We could see some investors start pricing in potentially higher rates of defaults or higher rates of downgrades. You could see credit spreads in the first half of 2024 begin to widen out a little bit. But then I think once you’re in the middle of the year, once the market then begins to price in that economic recovery we expect later in the year, I’d expect spreads to go back to where they are now. That’s why overall, I think a market-weight or a neutral position in corporates is probably the right way to go.

This is an excerpt from this week’s episode of Monday Morning with Morningstar’s Dave Sekera. Watch the full episode, 5 Cheap Stocks to Buy Before Interest Rates Fall Further. See a list of previous episodes here.

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