Bond Bull Party To Carry On
PGIM Fixed Income’s Greg Peters sees a broad-based fixed-income story. Watch this video or read PGIM Fixed Income’s quarterly outlook to learn more.
With yields up at levels not seen in more than a decade, bonds are definitely catching the eye of investors. But with equities delivering strong gains and Treasury curve inversions incentivising investors to idle in cash, will bond returns be competitive? In the current market environment, we see a compelling case for rebalancing into bonds vs. both stock and cash. The figures below tell the story, highlighting the pros and cons of cash, bonds and stocks, as well as their roles in portfolio construction.
Before jumping into the figures, a few conclusions to set the scene:
- True, cash rates remain high. But unlike bonds, the returns from cash over the long term are highly uncertain. And to that point, central banks are preparing to cut rates.
- Equity valuations look full relative to bonds. This is not so much a knock against stocks, but this configuration has historically signaled that bonds are set to deliver better-than-average returns and Sharpe ratios.
- In environments where central banks are on hold or cutting rates, bonds have historically been good shock absorbers, on average delivering solidly positive returns in quarters when equities experience steep declines.
CASH MAY NOT OUTPERFORM OVER THE LONG TERM
Cash may seem like the preferred option amidst the inverted yield curves. But, over time, the certainty around expected cash returns logically declines. In contrast, given bonds’ long durations and longer maturities, they provide a level of certainty or confidence for a targeted level of return. Therefore, cash may actually be the riskier option over the long term.
Correlation of starting yield with forward returns (1962-Present)
Source: PGIM Fixed Income, Haver as of May 2024. Note: Forward returns calculated by reinvesting in each instrument at a monthly frequency. Non-overlapping windows are used for each forward return horizon.
RELATIVE EQUITY VALUATIONS RAISE A CASE FOR BONDS
Whether you’re looking at the last few years, or the last century, equities might seem like the place to be. Notwithstanding the excellent wealth building capacity of stocks over the ultra-long run, in the current context, it’s worth considering that the recent repricing of bonds has taken yields to generational highs; the same cannot be said of equity valuations. For example, comparing the earnings yield of the S&P 500 with the 10-year Treasury yield shows that stocks have lost their relative valuation advantage vs. bonds. Additionally, bonds have tended to be much more efficient—e.g., higher Sharpe ratios —from the current relative yield levels.
FORWARD RISK-ADJUSTED RETURNS FAVOUR FIXED INCOME WHEN BONDS YIELDS ARE HIGHER THAN EARNINGS YIELDS.
Source: Bloomberg, Haver, PGIM Fixed Income as of April 2024. Note: Sharpe ratios calculated from rolling 12-month forward excess returns (over cash) from relative starting valuation. The line on the left-hand side chart represents the 45-degree line, which delineates whether bond yields are higher than earning yields. Trailing earnings yields are used for the analysis.
Source: PGIM Fixed Income.
WHEN STOCKS FALL, BONDS HAVE BEEN A BETTER SHOCK ABSORBER THAN CASH.
While over the very long term, equities may post the highest total returns, it is worth keeping in mind that their near-term risks can be high. Even over 10- to 15-year horizons, there may be periods when equity returns only match, or even fall short of, the returns on bonds or cash.
Which is the best shock absorber, cash or bonds? When looking at quarters when stocks were down 5% or more, bonds generally posted higher returns than both stocks and cash. Furthermore, bonds’ outperformance widens when the Fed is on hold or cutting—which seems to be the kind of environment we are in now.
Cash vs. bonds during quarters when equities declined by at least 5% (1962-Present)
Source: PGIM Fixed Income, Haver as of April 2024
THE OVERALL FIXED INCOME BACKDROP LOOKS PROMISING
In contrast to equities—where price-earnings ratios are high and earnings yields are low—the revaluation in bonds has taken yields back to levels not seen for more than a decade. For long-term investors, this is a critical point: if past is prologue over the long term, these yields are likely to translate into returns.
Source: Chart left: Bloomberg as of May 2024. Chart right: PGIM Fixed Income. "Yield is Destiny; Bonds are Back," The Bond Blog, PGIM Fixed Income, December 20, 2022
With the return of the “High Plains Drifter” regime of elevated bond yields, the investment landscape continues to shift. As a caveat, it is worth noting the obvious: we cannot rule out a bearish scenario playing out from current yield levels, in absolute or relative terms, vs. cash and stocks. But as equities scrape record highs and central bank policy rates crest, the preceding pictures support the case for diversifying into bonds.
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