Bonds are facing a tough year as they suffer losses for the third consecutive year, something that has never happened before in the history of the U.S. Republic1. The U.S. Treasury bond indexes are down as much as 2.5% this year, mainly due to the hawkish shift in the Federal Reserve’s policy outlook1. The Fed is expected to raise interest rates and shrink its balance sheet until inflation is under control, which could put more pressure on bond prices1.
However, some fund managers are not giving up on bonds yet. They argue that bonds are now cheap enough to offer attractive returns, especially compared to stocks, which have become expensive and risky1. The equity risk premium, the compensation investors demand for holding stocks over bonds, is by some measures the lowest in 16 years1. Moreover, the coupon on U.S. Treasuries is high enough to cushion the impact of further yield increases1. For example, a 50 basis point rise in the 10-year yield from current levels would result in a price fall of around 4%, which is more than offset by the current yield of 4.75%1.
“We would be holding onto bonds here. We would not be looking to sell at these levels,” says Keith Lerner, co-chief investment officer at Truist Advisory Services1. "You are getting better compensated now."1
Bonds may also benefit from some positive factors in the fourth quarter, such as seasonal demand, lower inflation expectations, and reduced supply. Historically, bonds tend to perform well in the last three months of the year, as investors rebalance their portfolios and seek safe havens2. Inflation expectations may also ease as some of the transitory factors that have boosted prices fade away2. Additionally, the U.S. Treasury may reduce its debt issuance in the fourth quarter, as it has done in previous years, which could ease some of the pressure on bond yields2.
At the start of 2023, many investors were optimistic about bonds, as they expected a strong economic recovery and low interest rates to support bond prices2. However, the reality turned out to be different, as inflation surged and the Fed signaled a faster pace of policy tightening2. Bonds have had a disappointing year so far, but they may still have a chance to redeem themselves in the final quarter.