Why Bonds Are Turning Everyone’s Heads Right Now

Let’s face it: the “40” side of the classic 60/40 portfolio has never been the sexier side. But lately, the bonds end of the tried-and-true 60% stocks and 40% bonds investment mix has been turning heads all along Wall Street. Here’s why Fidelity, BlackRock, Oaktree, and other giants are finding themselves seduced by bonds and their risk-adjusted returns.

Why are bonds suddenly so good-looking?

Bonds weren’t really doing their job these past two years – that is, acting as a diversifying hedge in the 60/40 portfolio –  because bonds were rising and falling in lockstep with stocks. But now, after the huge decline in bond prices (and an increase in yields), they’re starting to offer some real value. And there are a few factors being touted as the reasons for pushing up rates among the longer-dated bonds: US deficits, persistent inflation, the softer US dollar, and the rise of long-term yields on Japanese government debt, among them.

Howard Marks is the legendary co-founder of Oaktree Capital Management, the biggest investor in distressed securities worldwide. He points out in his most recent letter to clients that the S&P 500 has returned just over 10% per year for almost a century, and everyone’s very happy with that performance (rightly so: 10% a year for 100 years turns $1 into almost $14,000). And right now, US high-yield corporate bonds are offering a yield of over 9% and private loans considerably more, so there’s a strong case for holding some forms of credit in your portfolio.

In other words, expected pre-tax yields from non-investment grade (i.e. lower-rated and riskier) investments now approach or exceed the historical returns from stocks. And that’s why, for the first time in many years, hedge funds and asset managers are checking out bonds.

Why is the risk/reward for bonds so attractive now?

Let’s start with a look at the yields: we’ve seen a move higher in yields and a move lower in price. (Remember, bond yields go up as their prices go down).

US Treasury yields on different maturities. Source: Bloomberg.

And it’s not just those higher yields that have bonds looking so beguiling. The risk/reward in long-dated bonds has improved. This means that the upside potential in bond prices from a move lower in yields is much bigger than the potential downside move if yields move higher. In fact, the risk-reward profile here has not been so good-looking in over a decade.

The answer has to do with the basics of how bonds work. As you probably know, the bond’s duration describes the average time it takes to receive a set payment. And its maturity date is when its principal is repaid. So the maturity and duration for a bond differ if there is a coupon: if a ten-year bond has no coupon, its duration (and its maturity) is ten years. But the higher the coupon, the lower the bond’s duration as it measures the time needed to receive the total cash flow.

Duration also tells us something else: the amount a bond price changes with a 1% change in its yield. So if a bond has a duration of eight years, and interest rates increase by 1%, the bond’s price will decline by approximately 8%. The duration of a bond changes at different levels of yield because the time taken to receive the cash flow changes. This change in duration is called the bond’s “convexity.”

So now take a look at longer-dated US Treasury bonds. You can see that the risk/reward looks particularly favorable.

The bond market’s risk/reward profile and its estimated 12-month returns, based on different yield movements. Sources: F/m Investments, Bloomberg.

A 20-year Treasury bond currently yields around 5%. But if yields fall by 0.5 percentage point, that same 20-year bond would return 11.3% over the next year. On the other hand, if yields rise by 0.5 percentage point, they would lose just 0.9% – for an 11:1 up/down ratio. This risk-reward profile is one reason why the iShares 20+ Treasury Bond ETF (ticker: TLT; expense ratio: 0.15%) could be a good investment right now, despite posting a total return this year of negative-11.7% and falling about 47% from its 2020 peak.

iShares 20+ Treasury Bond ETF five-year performance chart, above, and its trading volume, below. Source: Bloomberg.

As you also may know, convexity is the reason why a 3% fall in yields on the 30-year Treasury can lead to a return of 75% or more, while a 3% rise would result in a loss of just 30% or so.

The potential pay-off is much more balanced in shorter-dated Treasuries. You can see that for a 0.5 percentage point move downward in yield, returns will be up 5.5% and a 0.5 percentage point increase in yields would provide a 4.6% return.

Treasury sensitivity to a 1 percentage point (or 100 basis point) move in interest rates, weekly data from 1997 to present. Sources: FMRCo, Bloomberg, Haver Analytics, Factset.

In 2020 (bottom left of the chart), the risk/return profile for seven- to ten-year bonds was +8.2% vs -7.2% for a 1% move in interest rates, so the potential return for taking on the risk wasn’t minimal – but now the return outcomes have moved to +12.1% to -2.5%. And it’s this change in the risk profile that makes bonds look more attractive now. In fact, you’d have to go back at least a decade to find a better return profile.

So what’s the opportunity here?

Well, that depends on your investment view and your risk profile. Yields on cash and short-term government bonds – called T-bills – are offering a little over 5%, and that’s more than the longer-dated bonds. So investing in money market funds or the SPDR Bloomberg 1-3 Month T-Bill ETF (BIL; 0.14%) could be sensible.

However, the main issue with holding cash and shorter-dated bonds is that there’s no guarantee you’ll be able to reinvest at the same high rate in the future. So, that being the case, it might be worth considering longer-dated bonds.

Predicting that interest rates are likely near their peak, BlackRock upgraded its tactical weighting for US long-dated Treasuries to neutral from underweight this week, after being underweight on the securities since late 2020. The asset management goliath says it’s not moving to overweight though, as it sees ten-year yields possibly moving higher toward 5%. The firm tactically likes shorter- and longer-term Treasuries and mortgage-backed securities as they have an implicit government guarantee and lower investment-grade (corporate) debt. For MBS exposure, you could consider buying the iShares MBS ETF (MBB; 0.04%).

Fidelity’s head of global macro, meanwhile, said this week that the improving risk/reward profile for medium- and long-term Treasuries makes an allocation in the iShares 20+ Treasury Bond ETF and/or the iShares 7-10 Year Treasury Bond ETF (IEF; 0.15%) look fairly appealing now. With BlackRock moving to a tactically neutral position and Fidelity and other major investment houses thinking the risk/reward looks favorable, it seems an allocation to the highest-yielding cash and short-term yields could be a shrewd move, along with dipping your toes into some longer-duration bonds.

But if you’re up for a bit more risk, you could go with Howard Marks’s view. He’s looking at US high-yield corporate bonds that are currently offering a yield of over 9% and private loans that yield considerably more. To dabble in this end of the risk spectrum, you could consider the iShares iBoxx High Yield Corporate Bond ETF (HYG; 0.49%) and the Goldman Sachs BDC (GSBD) for private credit.