For many investors, 2023 might be the first time to consider bonds in their adult lives.
That’s the takeaway from an insight published recently by Goldman Sachs, which forecasts that 2023 bond yields will exceed stock dividends. This, the paper says, hasn’t happened since the height of the Great Recession in 2008. Per the report:
“Bond yields trended down following the global financial crisis, making stocks seem like almost the only choice for investors seeking attractive returns. In fact, equities have materially outperformed bonds since 2008 and especially since the COVID-19 crisis — the relative performance of the S&P 500 Index versus U.S. 30-year Treasury bonds has reached new peak levels this year, much above those during the tech bubble.”
Now, to be clear, this report refers specifically to yields rather than returns. That is, Goldman is writing about the interest payments on bonds relative to the dividend payments from a stock portfolio. Capital gains returns are a separate area, one in which stocks tend to outperform bonds during most economic environments.
However to see stocks reliably outperform bonds on income has been an unusual feature of the past 14 years. Bond interest often exceeds stock dividends because of their reliability. A stock might issue strong dividends at any given time, but bonds issue steady, fixed payments. That stability tends to add up to greater overall yields for bonds, although it hasn’t been the case for a long time.
So it it time to dip into bonds? Read on for more insights, and as always, consider matching with a vetted financial advisor for free to strategize whether increased bond exposure makes sense for your particular financial plan.
Why Are Bonds Set to Be Hot?
Much of this has to do with jobs.
Despite officially exiting recession in mid-2009 the U.S. job market remained weak for another seven years. It wasn’t until 2016 that the unemployment rate reached what economists consider “full” employment, around 4%.
In response, the Federal Reserve kept its benchmark interest rate at or near zero from 2008 until 2017. Although it raised rates as high as 2.4% by mid-2019, that process was interrupted by the COVID-19 pandemic, which forced the Federal Reserve to crash rates back down to zero.
The bond market swings heavily on the interest rate set by the Federal Reserve. In part, this is because many bonds set their own interest explicitly based on this rate. They define their bond rates as the central bank’s rate plus a certain markup, meaning that an era of low Federal Reserve interest rates by definition means an era of low market bond rates.
In other part, this is because U.S. Treasury bonds (a shorthand for all Treasury debt instruments, including notes and bills) set their interest rates based on the Federal Reserve’s rate. Treasury bonds are considered the benchmark “safe” assets that the private market always has to beat. If a company’s bond offers lower interest than the government does, investors will simply purchase Treasury debt for its guaranteed return.
As a result, persistently low Federal Reserve interest rates kept the bond market weak for well over a decade. At the same time the U.S. stock market went on a run. Between 2009 and late 2021, the S&P 500 climbed from around 740 points to more than 4,700.
That growth applied to dividend payments as well. In most years during this period the average S&P 500 dividend yield hovered at 2% or higher; a figure that meant significantly higher payments as those average dividends climbed from 2% of 740 points to 2% of 4,700 points.At the same time the Bloomberg U.S. Aggregate, a standard benchmark for bond returns, posted yields consistently below 1%. Frequently it posted average annual losses.
Goldman sees this ground changing.
“[A]fter a sharp increase in bond yields this year, new and potentially less risky alternatives are emerging in fixed income: U.S. investment grade corporate bonds yield almost 6%, have little refinancing risk and are relatively insulated from an economic downturn,” Goldman said in its report. “Investors can also lock in attractive real (inflation-adjusted) yields with 10-year and 30-year Treasury inflation protected securities (TIPS) close to 1.5%.”
This is by contrast with a standard, if soft by comparison, S&P 500 dividend yield of around 1.7%.
“The gap in yields between stock and bonds has narrowed substantially since the COVID-19 crisis and is now relatively low,” the Goldman report read. “The same is true for riskier credit, which yields relatively little compared with risk-free Treasuries. Investorsaren’t getting much compensationfor the risk of owning equities or high-yield credit in comparison to lower risk bonds.”
For investors, Goldman sees two strong upsides to bonds in this market.
First, income investors can simply collect better gains. Bonds yield fixed, scheduled payments that you can plan around. For many investors who want to generate cash off their portfolios, that’s preferable to the unpredictable nature of dividend payments. Now they can get that predictability without serious opportunity cost.
Second, and perhaps more consequentially, Goldman sees this as a safe harbor in case of a coming recession.
“[E]quities,” Goldman said, “and high-yield debt are particularly exposed to an economic slowdown or recession.”
Often the value of stocks during economic volatility is as a hedge against inflation. Share prices and dividends tend to move cyclically with the value of money, so investors can expect combined stock returns to track inflation to a degree. By contrast, fixed-income assets tend to generate low returns relative to high inflation. However most analysts expect inflation to decline in 2023, reducing this downside protection to a stock portfolio.
Instead, most economists and investors see the main risk in 2023 as an overall downturn (a recession). In that environment, equities are particularly exposed while the fixed value of bonds tends to be a strong hedge.
It’s been more than a decade, but for the first time since T-Pain topped the charts investors at Goldman Sachs are recommending bonds as the smart play for income investors.
The Bottom Line
Goldman Sachs expects bond yields next year to exceed stock market dividends for the first time since 2009. That’s particularly good news, because a potential recession might make stocks a tough investment.
Tips for Investors
That’s great for Goldman Sachs to recommend buying bonds, but how exactly do you do that?
Bonds are good for a market downturn. A long term investment plan is better. Best of all, though, is smart, sound and professional advice. With SmartAsset’s matching tool, you can find a vetted financial professional for free to help you make a plan for potential recessions and long beyond. It just takes five minutes.
Photo credit: ©iStock.com/shapecharge
The post Goldman Forecasts The Best Bond Market In 14 Years appeared first on SmartAsset Blog.
