Unveiling the Compelling Bullish Outlook on Bonds: A Must-Read for Investors!

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The writer is global head of fixed income research at HSBC, based in Hong Kong

There are three compelling arguments supporting the troubled US Treasury bond market: fading momentum, restored value, and opportunity cost. These factors remain relevant regardless of your long-term fundamental view on interest rates and yields.

Firstly, the momentum behind the bond bear market is gradually slowing down. This can be observed through the trajectory shift of the three-month US Treasury bill, which is sensitive to monetary policy. Starting with a yield close to zero in January 2022, it rapidly increased due to the hawkish turn of the US Federal Reserve, reaching 1.67% in the first six months of 2022 and eventually surging to 4.50% by the end of the year.

In 2023, there has been a significant deceleration. The increase of 1 percentage point, reaching 5.50% in the first week of September, is much smaller compared to the surge of 4.50 percentage points last year. The peak hawkishness occurred over a year ago, as forecasted by the majority of experts who predict no hike at the September 20 meeting. Furthermore, based on the futures market, many believe that there will be no more hikes from the Fed in this cycle.

However, policymakers now face the challenge of preventing the market from anticipating rate cuts and adjusting positioning accordingly. The Fed is currently benefiting from the “higher for longer” approach, as it awaits the delayed impact of the previous hikes. Policymakers refer to this as forward guidance, but ultimately, events and data will determine the outcome.

Secondly, attractive valuations are enticing bond investors. The 10-year Treasury’s real rate, which accounts for inflation, is close to 2.0%, surpassing the trend for real GDP projected by the Fed at 1.85%. This uncommon scenario allows investors to diversify from the stock market by choosing bonds, which traditionally carry less risk.

Of course, this could change if economic growth trends are revised higher, warranting a further increase in the real rate. However, we doubt this will be the case. Much of the recent growth was driven by fiscal stimulus, and the burden of servicing the surging debt stock will ultimately weigh on future growth.

Moreover, the relative valuations of Treasuries compared to other G7 government bonds are also appealing, given the greater hawkishness of Fed policy compared to other central banks. This year, it is the riskier segments of fixed income, such as credit and emerging market local rates, that have performed well. If holding these assets is based on an eventual shift in the US rate cycle, it is logical to hold the bonds that will benefit the most, which are US Treasuries.

Lastly, there is the opportunity cost for investors who choose to stay in the safety of Treasury bills during this bear market. Currently, the yield on a 10-year security is about 1% lower than that of a Treasury bill. The intuitive view might question why investors should take the risk of owning a longer-term security. However, this perspective overlooks the potential benefits foregone by not selecting the alternative option.

Bonds offer a fixed coupon throughout their lifespan and have higher duration, meaning their price is more sensitive to future interest rate decisions. On the other hand, bills have minimal duration but carry high reinvestment risk since the yield at maturity is uncertain. For instance, comparing a 10-year bond yielding 4.25% with a bill yielding 5.25%, a price gain from a slight decrease in bond yield coupled with the coupon payment could equal the higher yield on the bill.

Admittedly, bond prices can rise and fall, making them riskier than bills. However, since the start of 2022 when the Fed adopted a hawkish stance, the yield on 10-year Treasuries has increased by a significant 2.66 percentage points. This translates to a price decrease equivalent to 21%! Consequently, if the trend from 2022 were to reverse and bond yields returned to levels last seen in 2007, the opportunity cost of not transitioning from bills to bonds would be substantial.

In summary, the momentum and value are currently in favor of bonds compared to a year ago. This should provide some reassurance to investors considering the opportunity cost of staying in the safety of bills. Buying bonds doesn’t require one to be unquestionably bullish.