The Bond Market is Flashing a ‘Smile’ After a Historically Bad Stretch, a Promising Sign for 2024

Certainly, the outlook for 2024 is shaping up to be the "year of the bond," signaling a significant shift in the dynamics of the U.S. debt market, valued at approximately $55 trillion. The emergence of a positive convexity, often referred to as a "smile," is a noteworthy development following a challenging three-year period for bonds. This transformation reflects a growing sense of optimism surrounding the conclusion of the Federal Reserve's series of interest-rate hikes and a prospective shift towards rate cuts.

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Convexity, a metric gauging a bond's value in response to fluctuating interest rates by examining yields and prices, plays a pivotal role in this context. As interest rates climb and bond prices dip, a negative convexity, or "frown," materializes. Conversely, when rates peak, a positive convexity manifests, resulting in an upward curve. Mark Cernicky, Managing Director at Principal Asset Management, emphasizes that as the dollar price of bonds decreases, convexity increases, proving advantageous for investors.

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The significance of high convexity lies in its ability to mitigate losses for investors during adverse events, such as rising interest rates, while also enabling them to capitalize on positive developments, like rate cuts, leading to a metaphorical "smile" instead of a "frown." Despite the prolonged anticipation of a U.S. recession, a widespread and convincing revival of returns in fixed income is yet to materialize. Nevertheless, economists and investors are increasingly considering the possibility of a soft economic landing or a mild recession in 2024, despite the apparent end of the era of relatively cheap money.

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The protracted wait for a recovery in the bond market has prompted many investors to stay parked in cash-like investments, including T-bills maturing in a year or less, offering attractive 5% yields. The appeal of these T-bills is heightened by their yields nearing the highest levels in almost two decades. The past three years have been particularly challenging for holders of longer-duration, low-coupon bonds, as evidenced by the negative 13.6% three-year return of the Bloomberg U.S. Aggregate index.

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Despite the challenges, some investors remain skeptical about whether inflation will be adequately controlled or if the next year will bring significant changes for bonds. Lindsay Rosner, Head of Multisector Fixed-Income Investing at Goldman Sachs Asset Management, notes that convexity can either work for or against investors. She highlights the story of the AGG, which began the year with a 4.65% yield but is now on track for a 0.7% yearly return due to the Federal Reserve's successive policy rate increases.

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The current narrative, according to Rosner, revolves around the Fed's persistent rate hikes as inflation continues to pose a concern. While the consumer-price index for October indicated a slowing annual inflation rate of 3.2%, the Fed remains vigilant about the potential reacceleration of inflation. Convexity, however, appears to be favoring bond investors as they approach 2024, raising hopes that the challenging period for U.S. bonds might be coming to an end.

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Rosner points out the evolving landscape, emphasizing that convexity also serves to measure the risks associated with bonds' upside or downside. The prospect of modest rate cuts by mid-2024, as anticipated by Fed-funds futures traders, could enhance the appeal of longer-duration bonds with higher yields. This momentum is reflected in the increased inflows into the iShares 20+ Year Treasury Bond ETF (TLT) this year, despite its less-than-stellar returns.

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Mark Cernicky of Principal emphasizes that the key advantage of high convexity in bonds today is that investors shouldn't wait until the Fed cuts rates to buy bonds. Anticipating a cut, yields are expected to decrease, leading to an increase in total return and a reduction in convexity. Cernicky underscores the importance of acting promptly, as delaying the decision diminishes the drop in yields and the benefits of convexity.

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