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Three in a Row?

We are now 10 months into 2023, which makes it a good time to review interest rate levels and bond performance. Despite the regional bank failures earlier in the year, the U.S. Federal Reserve has continued to raise overnight rates to combat ongoing inflation and has even doubled down recently on its hawkish rhetoric, with a “rates will be higher for longer” message seemingly everywhere in the press. Intensified government borrowings, a Fitch downgrade of the U.S. credit rating over the summer and a recent surge in oil prices have added to renewed fears about persistent inflation.

Indeed, during the second and third quarters of 2023, interest rates resumed their steady march higher, with the 2-Year and 10-Year U.S. Treasuries reaching 5.16% and 4.68% respectively in late September. Higher rates mean lower bond prices, and we have seen bond returns suffer as a result. After two calendar years in a row of negative bond returns and a record down year for bonds in 2022, 2023 has so far added a bit of insult to injury, as evidenced in Table 1 below.

Table 1. Bond Benchmark Returns (%Total Return)*

  Avg Annual Return since 1980** Avg Annual Return since 2000 2021 Full-Year Return 2022 Full-Year Return Year-To-Date Sept. 30, 2023
Bloomberg Intermediate U.S. Government/Credit 6.32 3.62 (1.44) (8.23) 0.65
Bloomberg U.S. Aggregate 6.69 3.80 (1.54) (13.01) (1.21)
Bloomberg U.S. Municipal 5.91 4.07 1.52 (8.53) (1.38)

*Source: Bloomberg LLC, Baird Trust
**Annualized returns since Jan. 31, 1980

For the first nine months of 2023, the Bloomberg Intermediate Bond benchmark returned +0.65% —not stellar, but certainly a welcome reprieve from the benchmark’s -8.23% return last year. On the bright side, with tax-equivalent yields approaching 6% across the corporate and municipal curves, we are set up for solid bond returns in the coming years. A lot has been written about the importance of “starting yield levels” and how they are the best predictor of future returns with respect to fixed income. Well now we have a “starting yield level” that we haven’t seen since the early 2000s. With many bonds yielding 6% or more, price drops driven by rate increases are more quickly offset over time than even a couple of years ago, when yields were only 2%.

In the short run, bond returns are driven by the change in interest rates; over the longer term, bond returns tend to mirror the average yield level. Bond investors have reason to be excited about the next several years, as the current ~6% yield of bonds should lead to much stronger returns going forward. Recall the famous “Rule of 72”:

72 ÷ Rate of Return (%) = Years required to double the original investment

According to the Rule of 72, bonds could now double an investor’s money in just over a decade. That’s not a bad result considering where yields have been the past several years. But this possibility is also not surprising: As we saw in Table 1, popular bond benchmarks have returned roughly 6% per year on average since 1980.

As we head into the fourth quarter of 2023, we realize that this could be yet another year of negative returns for bonds – making it three in a row. This has never happened before. Happily, unless yield levels continue to rise into year-end, intermediate bonds are likely to finish 2023 with positive total return. Either way, the bond market is currently full of opportunities that are yielding a full five percent per year more than just three years ago. Just a quick peek across the fixed income landscape reveals money markets, Treasury Bills, FDIC-insured bank CDs and high-quality corporate and municipal bonds all with yields well north of 5% and sometimes above 6%. A typical one- to 10-year bond ladder at Baird Trust now has an average yield of more than 5.50%.

Fruits & Vegetables?

Sometimes we do things just because it’s the smart thing to do, like including fruits and vegetables in our diet. At Baird Trust, we construct fixed income portfolios with future cashflow needs in mind because it’s the smart thing to do. With bonds, it is often possible to structure them in a way so that coupon flows and maturities align smoothly with a client’s cash needs.

But cash flow needs can change, which is why we also place high importance on including “liquid” bonds as part of any fixed income portfolio – bonds that, like stocks, can be sold if cash flow needs change.

Unexpected cash needs might arise from sudden business expenses, college tuition, the purchase of a second home, an unscheduled gift or even a bucket list vacation. Further, tax loss harvesting, a change in risk tolerance or rebalancing into stocks can all be reasons to sell bonds. And occasionally the need to sell a bond occurs simply because we see an opportunity to buy a more attractive one.

So what makes a bond liquid? Three main factors are size, quality and recency of issue. First, the larger the bond size, the more numerous buyers and sellers will be. Many bonds issued today have a billion dollars or more of par value outstanding and trade nearly every day. Second, higher-quality, investment-grade bonds usually attract more buyers than lower-quality ones – many institutional bond buyers, such as banks, mutual funds and insurance companies, will not purchase below-investment-grade bonds. Third, how long ago a bond was issued often affects current buyer interest, with more recently issued bonds typically trading more frequently than older issues. As bonds age, they tend to be “put away” and held to maturity by most investors.

Can having highly liquid bonds in your portfolio be a good thing even if coupons and maturities turn out to be sufficient to meet cash needs and your portfolio never needs rebalancing? We like to think so. If nothing else, the ability to easily convert bonds into cash can give investors peace of mind. Including highly liquid bonds in your portfolio can be a bit like eating your fruits and vegetables. As my doctor says, “It can’t hurt!”

Baird Trust Company (“Baird Trust”), a Kentucky state chartered trust company, is owned by Baird Financial Corporation (“BFC”). It is affiliated with Robert W. Baird & Co. Incorporated (“Baird”), (an SEC-registered broker dealer and investment advisor), and other operating businesses owned by BFC. Past performance is not a predictor of future success. All investing involves the risk of loss and any security may decline in value. This is not intended as a recommendation to buy or sell any security and views expressed may change without notice. Baird Trust does not provide tax or legal advice. This market commentary is not meant to be advice for all investors. Please consult with your Baird Financial Advisor about your own specific financial situation.