Bonds Shine with Fed's "Higher for Longer" Call

MIKE TOWNSEND: I've been an investor for more than 30 years. I'm not a trader. I buy and hold. My own portfolio, it's the very definition of boring. And bonds, they've just never been my thing. I've always had bond funds as part of my diversified portfolio, but I've never paid much attention to them, and I have never bought an individual bond in my life. But now, however, bonds are kind of exciting, or at least interesting. Last week, the yields on both the 5-year and the 10-year Treasury bonds hit their highest level since 2007. Even the 30-year bond hit its highest yield since 2011. There are ample opportunities out there to lock in solid returns, barring defaults, and reduce the volatility in a portfolio with some strategic use of bonds. So should investors like me who are, well, let's call it bond indifferent, be rethinking their stance? Welcome to WashingtonWise, a podcast for investors from Charles Schwab. I'm your host, Mike Townsend, and on this show, our goal is to cut through the noise and confusion of the nation's capital and help investors figure out what's really worth paying attention to.

In just a few minutes, I'm going to talk with Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research, about what's going on in the bond market and how to take advantage of what some are calling a generational opportunity for bond investors. But, first, a couple of quick updates on what's making news right now here in Washington.

At the top of the list, of course, is the looming government shutdown. Congress made basically no progress at all last week on solving the government funding conundrum. Internal battles among Republicans have thrown the House of Representatives into chaos, and it looks likely that even a short-term extension of government funding, known as a continuing resolution, may have a difficult time passing the House this week. Meanwhile, the Senate is moving towards a short-term extension that includes emergency funding for domestic disasters and additional aid for Ukraine, something that is also dividing House Republicans. Put it all together, and it's hard to see how Congress pulls a rabbit out of a hat to keep the government open and operating past the September 30 deadline.

So what does a government shutdown mean if it happens? Well, here's what you need to know. First of all, as I mentioned on the last episode, shutdowns are not typically big market movers, but they can produce some market volatility. In the last shutdown, which started in late December of 2018 and lasted 35 days until late January of 2019, the S&P 500^® dropped by more than 2½% on the first trading day after the shutdown began, only to rebound by more than 5% on the next trading day. Ultimately, the market gained more than 10% during the shutdown, but that was a historic outlier. Over 20 government shutdowns dating back to the mid-1970s, the average market performance has been a microscopic gain of 0.1%.

But there are other potential impacts investors should keep their eyes on. Each federal agency makes its own contingency plan for operating essential services during a government shutdown. Employees in key roles—think air traffic controllers, border security agents, military personnel, the postal service, and many more—would continue to work, though paychecks may be delayed. Non-essential services, however, will be paused. In the 2018-2019 shutdown, an estimated 850,000 federal workers were furloughed. Treasury markets and the stock market would continue to operate normally during a shutdown, but Security and Exchange Commission Chair Gary Gensler said in a September 20 interview that the agency's normal oversight on markets will not be possible during a shutdown because the SEC would have a skeletal staff due to furloughs.

Another notable impact is that key economic data releases are likely to be delayed in a shutdown. The Bureau of Labor Statistics said last week that it would suspend data collection, processing, and dissemination if the government closes, which would impact a number of reports that the Fed relies on to understand what's going on in the economy. A shutdown would first impact the Job Openings and Labor Turnover Survey, known by its acronym as the JOLTS Report, which is due to be released on October 3. The Non-Farm Payrolls Report is scheduled for October 6. A longer shutdown could impact the release of the Producer Price Index, or PPI, and Consumer Price Index, or CPI, data scheduled for release on October 11 and 12, respectively. If this data is missing or delayed, it could impact the Federal Reserve as it assesses the state of the economy in advance of its next monetary policy meeting on October 31 and November 1.

The Bureau of Labor Statistics is just one of countless government functions that are deemed non-essential. In past shutdowns, the closure of national parks and the Smithsonian Museums were among the most visible impacts to the public. The processing of passport and Social Security applications would be suspended, though Social Security and other benefits would continue to be paid out. In a change from previous shutdowns, the Internal Revenue Service would continue to operate because last year's Inflation Reduction Act made additional funding available for the agency.

In Washington, preparations are being made at every agency because there's a growing sense that a shutdown is all but inevitable, and that it won't be resolved quickly.

Meanwhile, on the regulatory front, there was an interesting development last week that should help ordinary investors. The SEC finalized a significant expansion of the Names Rule, which addresses, quite literally, the names of mutual funds and exchange-traded funds. In recent years, the SEC has grown increasingly concerned that funds use trendy words in their names to capture the attention of investors, even if those names don't really reflect the strategies and goals of the fund. There's been a particular focus on funds that use words like "green" and "sustainable" in their names to attract investors interested in   I

ly friendly investing. Under the new rules, funds using those and other descriptive terms in their name, including terms like "growth fund" and "value fund," or geographic references will be required to invest at least 80% of their portfolio in assets that match that description. Funds will have to define for investors the terms used in the name and explain how their strategy matches the name. The rule won't go into effect for two years, but when it does, SEC Chair Gensler said that it should build on the basic idea that a fund's investment portfolio should match a fund's advertised investment focus. Notably, the rule also attracted the support of Republican Commissioner Hester Peirce, who rarely agrees with Gensler on much of anything. Peirce said that the new requirements recognize that names do matter, but they should not be the only factor considered by investors when making an investment decision.

On today's Deeper Dive, with everything going on at the Fed, we're going to take a look at implications for the bond market. Investors who have been on the sidelines about bonds are taking a real interest, given that bonds are seeing their best returns in more than a decade. There's no one better to answer our bond questions than Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research. Kathy, welcome back to WashingtonWise.

KATHY JONES: Great to be here, Mike.

MIKE: Well, let's begin with the Fed. Last week, the Fed held rates steady but left the door open to another rate hike before the end of the year as it continues to battle inflation. And notably, it signaled that rates may not go down as much in 2024 as was previously suggested. But Chair Jerome Powell, I felt like he really didn't say anything particularly new. So give us your takeaways from the meeting and from Chair Powell's press conference.

KATHY: Well, you're right, Mike, Powell really didn't say anything that new. He has been saying all along that the Fed would keep policy restrictive, with rates high enough to slow the economy until inflation recedes. And that was really reiterated both in the statement and in the commentary.

I think what the market reacted to was the shift in the estimates for rate cuts in 2024. The dots on the dot plot, which are estimates that Fed members provide about where they see the policy rate going over the next year, all shifted to fewer rate cuts next year. And so the bond market sold off because that higher-for-longer message really wasn't fully discounted ahead of time. If the fed funds rate is going to stay where it is or even move higher beyond the 5½% upper bound where it is now into the first half of next year, then all yields have to adjust higher, and that means bond prices go down.

MIKE: One of the things that Powell says at just about every press conference, and he reiterated it again at the most recent one, is just how much the Fed relies on data. Now, if Congress can't come to a resolution on the current spending fight, we could be facing a government shutdown next week. And as I mentioned earlier in the podcast, that will cause a delay in some of the key data releases that the Fed relies on to make decisions, including the JOLTS numbers and PPI and CPI data. The next Fed meeting begins October 31. So if between now and then we have a government shutdown, and they don't have the key data that they tend to use, will they just have to punt?

KATHY: Well, it looks like that might be the case because it does make the Fed's job harder, and without information about the economy, how can anyone make a decision? There are some sources of information in the private sector, but those typically are not as comprehensive, so the Fed can't really get a good handle on what's going on from a big picture point of view. And it's already been struggling because the response rate to the various surveys that go out on things like unemployment has been very low, which makes the numbers subject to large revisions anyway.

Now, it is also coinciding with the auto worker strike, which is likely to have some impact on the job figures if that lasts. So there's a whole stew of things that the Fed may not have information on. They're sort of staring into a void. So my guess is that the reaction that the Fed would be just to keep policy unchanged until there's more clarity on the information.

MIKE: Well, Kathy, a different question on the possible government shutdown. Would Treasury be able to issue new bonds during a shutdown? I guess the larger question is, anything for investors to worry about in terms of bonds that mature during a shutdown or anything like that?

KATHY: It seems unlikely. Treasury hasn't made an announcement yet, but based on the last time there was a government shutdown, what the Treasury continued to do was just function normally. So it paid off maturing bonds, and it issued new ones on a regular schedule. I would assume it's considered a vital function just like the military, and therefore it would continue to act as normal.

MIKE: Well, let's talk more broadly about the investing environment for bonds. Presumably, yields will fall as we head into 2024 and inflation continues to abate. So is this the time for investors to look at longer durations? I mean, how far out can I lock in some of these great rates?

KATHY: Well, we do expect inflation to continue to fall, and I want to point out it has already fallen quite a bit by whatever measure you want to use. So if you're looking at the benchmark measure that the Fed uses, which is the deflator for core personal consumption expenditures—I know that's a mouthful, but it's core PCE—it has declined to about 4.2% a year-over-year from 5.6% late last year. And the overall measure that includes food and energy is down from a peak of nearly 7% to about 3.4%, so it's fallen in half. We tend to look at the recent rate of change figures to see what the momentum is, which direction the momentum is in inflation. And so when we look at the core numbers that are coming in about 0.2% per month, that means on a three-month rate-of-change basis, you know, we're down to an annualized rate of about 2.4%. And a few more readings of 0.1 or 0.2 means that we'll hit that 2% Fed target in the next couple of months. So we're pretty encouraged about inflation coming down, and that typically means that yields will fall as well.

Right now, when we look at the level of real rates, that is the rate adjusted for inflation expectations, we find that attractive. For investors, that means locking in a rate that compensates for inflation. And if we're right that inflation falls, it has the potential for capital gains as well.

Now, in terms of your question on duration, it really depends on the investor. In general, we look at the Bloomberg Aggregate Bond Index for a benchmark—it's very similar to the idea of the S&P 500 as representing the broad market. It's the same with the Ag, as we call it in the bond market. Right now, the Ag has a yield-to-worst of 5.3%, and duration of 6.1. So the yield-to-worst is just a way to describe the worst possible yield you can get. It adjusts for things like the possibility that a bond might be called in early. So it's the yield we watch most closely. What that means is, if you have a holding period of roughly five to seven years, then you should get that 5.3% yield in these high-quality bonds. And we think that that's a pretty reasonable and attractive proposition right now.

MIKE: What about corporate bonds? I've seen some analysts describe this as a generational opportunity to lock in very high yields for several years, which sounds pretty appealing. What do you think?

KATHY:  Well, we have liked investment-grade corporate bonds at these levels because we think the risk-reward is attractive. In general, these are bonds issued by bigger companies that have more solid balance sheets. You know, there is still interest rate risks. So if interest rates go up, bond prices come down. But nonetheless, we're looking at yields of about 5½% over five to seven years, without elevated credit risk. And, again, we think that looks pretty good for most investors. So many of these companies locked in lower interest rates by issuing longer term debt a few years ago when rates were low. Most of the increase we've seen in yields has been due to the Fed rate hikes, not to a deterioration in credit quality. The risk would be that potential downgrades happen if the economy weakens significantly, but it's more likely to have a big negative effect on high-yield or junk bonds rather than investment-grade. So from our point of view, this is an opportunity for investors looking for yields above 5% without having to take a huge amount of risk of default.

MIKE: How about Treasury Inflation-Protected Securities, or TIPS? As the name says, their purpose is to offer protection against inflation. It certainly made a lot of sense as inflation was going on that wild upward ride last year. But when inflation comes down, as it is now, do they still make sense?

KATHY: Yeah, TIPS can be pretty compelling at these levels. Even if inflation falls, what you get in TIPS, it will likely still have a positive return. In TIPS, the rate you get is inflation indexed. So that means that the bond is indexed against a CPI, the overall CPI, the one that includes food and energy. The income and principal get adjusted every year by the rate of increase in the CPI. So they are designed to keep pace with inflation. And right now, the rates you're getting are roughly 2 to 2¼% region, depending on the maturity of the bond. So that means you get that yield and the inflation rate going forward.

We tend to look at them in terms of the inflation rate that's kind of discounted in the market pricing compared to, say, overall nominal Treasuries. Currently, when we look at that, the yields for TIPS provide the real rates of 2, 2¼% for maturities of five to 10 years. So that means if you hold to maturity, you should get an after-inflation return of 2%, and that's actually the highest real yield in the Treasury market that we've had since about 2007.

So when you compare that to other types of yields such as, say, dividend yields on stocks or even earnings yields in the stock market, they look pretty good. I mean, these are comparisons people make to look for things to protect them from higher inflation down the road. The TIPS look pretty good to us in terms of real yields relative to potential volatility. For example, in stocks, the long-term real return has been about 6% over time, but that comes with three to six times as much volatility as in the Treasury market. So looking at real earnings yields in the stock market, they're low because the price/earnings ratio is high by historical standards.

So the math goes like this. If the P/E is 20, then the earnings yield is roughly 4.7 to 5%. Subtract, say, 2½% for inflation, and you get a real earnings yield of 2.2 to 2½%. That's about what you get in TIPS, but with significantly less volatility than you get with stocks. And that's what makes TIPS look pretty attractive to us.

MIKE: Well, what about municipal bonds? They can offer a tax incentive when held in a taxable account, and that's a nice draw, but how safe are they? Will states and counties, cities, who can't print more money, be more likely to have trouble repaying their debts if the economy stalls out?

KATHY: Well, the good news is that credit quality in the municipal bond market is holding up very well. Most state and local governments are still seeing solid revenue growth since much of the revenue they get is derived from things like income taxes, sales taxes, and property taxes, all of which have been rising. And there have been more upgrades than downgrades by the rating agencies that reflect these trends. In an economic downturn, there may be some muni bonds that perform poorly, but often these are in the riskier segments of the market already, like hospital bonds and areas that are experiencing slow growth. Usually, this is already reflected in the yield and/or the credit rating. Many of these may be rated below investment-grade or in the junk category.

Now, on the negative side in the municipal bond market, valuations are not exceptional right now relative to history. There's been a very strong demand for municipal bonds, especially short-term bonds, as yields have risen. And consequently, the yield relative to Treasuries is on the low end of historical average.

But it all really does come down to the after-tax return to the individual investor. If you're in a high tax bracket, in a high tax state, munis probably still are a good investment to have in your fixed income portfolio.

MIKE: Well, Kathy, you've given us a little tour of the bond world. We've talked Treasuries, we've talked TIPS, we've talked corporate bonds, we've talked municipal bonds. I guess put it all together, and bond investing suddenly seems kind of exciting again, I've always felt like putting bonds in a portfolio has been the equivalent of eating your vegetables. You know, have to have some, but you're not that thrilled about it. A lot of investors satisfied that need with a few low-calorie bond funds, and then they employed the set-it-and-forget-it attitude, and I freely admit I'm in that category. Now, however, bonds are kind of a hot thing. They have returns that feel competitive with stocks, and it feels like investors can and probably should have a real bond strategy in place. The question is, can you be strategic and get the full benefit of the opportunities available today if you are in bond funds, or do we need to be looking at individual bonds or maybe a combination of both?

KATHY: Well, personally, Mike, I have to say I have always found bond investing exciting, but I am glad to see other people jumping onboard. Now that yields are up, a lot of people are finding them much more compelling than they have for a decade and a half. So here are a couple of thoughts on how to go about getting involved and what you might consider talking to your financial consultant about.

First, remember, bonds are mostly about generating income, preserving capital, and diversifying from stocks. And a lot of people are looking at the wide price fluctuations of the past few years and getting concerned about price declines. But overall, the focus should really be on the opportunity to generate that income provided by the bond's coupon and potentially reinvesting that for more income longer term.

Now, if you focus on those three goals—income, capital preservation, and diversification—then there are opportunities that look attractive for most investors, even if yields do move up from here.

Individual bonds are pretty straightforward, since you can plan on the income stream, and the timing of those coupon payments, and get your principal back at par, barring a default, when the bond matures. So it makes it easier to ignore the price fluctuations. But not everyone has the resources to build a portfolio of individual bonds. I mean, you need a fair amount of money to get enough diversification, and not everyone really wants to do it themselves.

So mutual funds can be a good alternative. The upside is that you typically get that professional management, which can be especially beneficial in this type of environment where there's a lot of volatility in the market. And you also get the potential to generate more income over time, since that's usually the goal of the bond fund manager is to manage the fund to generate more income. However, you have to deal with potential declines in the fund's net asset value and uncertainty about what the price will be at any given point in time in the future. And so unlike individual bonds, you don't have your own cost basis, which may be an issue for dealing with taxes.

But all things considered, the way we suggest going about it is match your investing time horizon with the maturities and/or the duration of the bonds you're investing in. Whether you're investing in individual bonds or in funds, we look at what type of bonds you have or that the fund holds, what the investment strategy is, and what the average maturity of the bonds are, and the duration. And duration is that measure of how sensitive the bonds are to changes in interest rates, and that gives you a sense of volatility. And you should try to match up your investing time horizon with the duration of the fund and hold for that period of time.

You know, I should mention that we have a lot of great resources on our website for bond investors. We have specialists that can help navigate the market, very experienced, have been doing this a long time, and understand the ins and outs of the market.

So, Mike, I'm glad there's so much interest in the bond market. We're here to help investors, whether they're seasoned in fixed income or whether they're new to it.

MIKE: Well, I am glad you mentioned some of the resources here at Schwab. There are a lot of investors, I think, particularly younger investors, who have literally never seen bonds with these kinds of returns. They may be missing out on opportunities to diversify their portfolios. So I really think this is the right time to learn more about the role bonds can play in a longer-term plan.

Kathy, as always, great information, great to hear from you. Thanks so much for making the time to talk to me today.

KATHY: My pleasure, Mike.

MIKE: That's Kathy Jones. You can follow her on X, formerly known as Twitter, @KathyJones, and you can find her latest commentary at schwab.com/learn.

Well, that's all for this week's episode of WashingtonWise. We'll be back with a new episode in two weeks. Take a moment now to follow the show in your listening app so you don't miss an episode. And if you like what you've heard, leave us a rating or a review. Those really help new listeners discover the show. For important disclosures, see the show notes or schwab.com/washingtonwise, where you can also find a transcript.

I'm Mike Townsend, and this has been WashingtonWise, a podcast for investors. Wherever you are, stay safe, stay healthy, and keep investing wisely.