After seemingly only heading in one direction (higher) as of late, U.S. Treasury yields tumbled in November on the back of softer economic data along with signs that the Federal Reserve (Fed) is likely done raising interest rates. Since touching 5% in October, the yield on the 10-year Treasury has fallen more than 0.75%, which helped core bonds (proxied by the Bloomberg Aggregate Bond Index) generate the best monthly return for the index since May 1985. After six straight months of negative returns, the positive monthly return was a nice reprieve. However, given the outsized fall in yields, some investors may be asking: Was that it? Was that the year for fixed income in one month? Of course not.
Despite falling meaningfully from the recent highs, yields for many fixed income sectors are still significantly above longer-term averages. And with that, the prospects for above-average returns remain high as well (no guarantees of course). Even after the big rally in bonds in November, given still high yields, it would not take much of a sustained drop in yields to generate high single digit/low double digit returns over a 12-month horizon for a number of high-quality fixed income sectors. For example, a 0.50% drop in yields would likely generate a 10% return (over 12 months) for AAA-rated agency mortgage-backed securities (MBS). Moreover, if the economy slows and the Fed cuts rates more than we expect next year, these high-quality fixed income sectors could generate 12%–13% type returns (again, no guarantees).
Equally important, these still high yields serve as a “hurdle rate”, or a yield cushion, that will need to be eclipsed before losses are realized. As such, these higher hurdle rates may decrease the probability of losses due to an increase in interest rates while at the same time these higher starting yields increase the probability of annual gains (as noted above). Yields would need to increase by 1% or more to offset current levels of income, which we think is unlikely given our expectations that the Fed is done with its aggressive rate hiking campaign.
The rally over the past month has been a nice break from the challenging return environment for fixed income investors over the past few years. However, given LPL Research’s view on interest rates, we think there is still room for Treasury yields to fall further in 2024, which would help support bond prices. And while we don’t expect November-type returns every month, we do think core bonds could potentially generate high single digit/low double digits in 2024.
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