As the anticipation builds for a possible rate cut by the Federal Open Market Committee (FOMC) later this year, bondholders are naturally wondering: "How will this affect bond prices?" The fundamental rule of bond performance states, "When interest rates go down, prices go up." But is a rate cut a guaranteed win for bond investors?
A Tough Stretch for Bondholders
Bond investors have faced challenging conditions in recent years. The Federal Reserve, under Chairman Jerome Powell, began tightening credit in 2022. The fed funds rate skyrocketed from 1.21% in June 2022 to 5.33% today. This aggressive tightening created a difficult environment for fixed-income investments, with the ICE BofA US Corporate & Government Index recording a -2.65% price return between June 2022 and July 2024. While current income partially offset these declines, many investors are still waiting to recoup their initial investments.
Recently, however, there have been signs that the tide may turn. Inflation, as measured by the Fed’s preferred gauge, the Personal Consumption Expenditures (PCE) index, has dropped to 2.5% from a peak of 7.1% in June 2022. Additionally, a disappointing July jobs report has fueled speculation that the Fed may need to cut rates to avoid a recession. But how would bond prices respond?
The Caveats: No Guarantees
Before assuming a bond market rally, it is important to consider a few caveats:
Uncertain Timing: It is not certain that the Fed will lower rates in the near future. Predictions about fiscal or monetary policy often prove unreliable.
Different Rates Impact Bonds Differently: The fed funds rate directly affects overnight bank lending rates, but bond yields, especially those on longer-term debt like the 10-year U.S. Treasury note, are influenced by different factors. While short-term rates are currently higher than long-term rates, a Fed-induced drop in short-term rates could merely normalize the yield curve, with minimal impact on long-term bond yields.
Market Expectations: Long-term rates have already declined significantly from their early-2024 highs, with the 10-year Treasury yield falling to 3.84% from 4.70% in April. It is possible that the market has already priced in a potential Fed rate cut, leaving limited room for further bond price appreciation.
Learning from the Past
Despite these uncertainties, historical precedent suggests that a bond rally is likely if the Fed cuts rates later this year or early in 2025. The ICE BofA US Corporate & Government Index has shown price gains of 4.4% to 5.0% in the six months following each of the three most recent fed funds rate cuts. While history does not always repeat itself, it often rhymes. We believe historical trends provide valuable insight into how the bond market might respond to a rate cut.
Start/End Dates | Fed Funds Rate (%) | Bond Index Price Return (%) |
7/31/2000-1/31/2001 | 6.54 - 5.98 | 5.01 |
7/31/2007-1/31/2008 | 5.26 - 3.94 | 4.51 |
4/30/2019-10/31/2019 | 2.42 - 1.83 | 4.43 |
Source: Bloomberg and ICE, Indices, LLC
Keeping Perspective on Bond Performance
While bondholders naturally prefer price appreciation, it is essential to remember that income is the primary driver of long-term bond returns. Over the twenty five years ending in 2023, income contributed slightly more than 100% of the Corporate & Government Index’s 3.90% annualized total return, with year-to-year price changes netting to a modest -0.25% per annum.
This outcome is not surprising. A noncallable twenty five-year bond purchased at $100 will be worth $100 when it matures, assuming it remains in good standing. The interim price fluctuations essentially cancel out over time.
However, active management can enhance returns. While predicting short-term interest rate movements is challenging, astute bond managers can potentially generate trading profits by capitalizing on temporary mispricing among various issues and sectors.
Bond investors should focus on maintaining the portfolio’s credit quality to ensure that scheduled interest and principal payments are received as promised. Reacting emotionally to fluctuations—whether actual or expected—can be counterproductive. The primary objective should be generating consistent income for current use or achieving long-term growth in principal through reinvested payouts.
Looking Ahead
As we await the Fed’s next move, the most prudent approach for bond investors is to stay focused on income generation and credit quality. While a rate cut could provide a short-term boost to bond prices, the long-term success of a bond portfolio depends on disciplined management and a clear understanding of the income-driven nature of bond returns.
If the Fed does cut rates later this year, it may signal a turning point for bondholders. However, the real value in bonds lies in their ability to generate steady income over time, regardless of the interest rate environment.
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