Looking for bargains amid the selloff? Consider bonds

Bonds haven’t been getting as much attention from investors as stumbling technology stocks and bitcoin during this year’s bout of financial market volatility, but some observers are now pondering opportunities in this beaten-up asset class.

A key reason: Bond yields have soared to levels where they are now challenging dividend-paying stocks, offering investors a level of income that hasn’t existed in years, at a time when economic clouds are moving in.

To be sure, bond yields are up because bond prices – which move in the opposite direction of yields – have tanked.

The yield on the 10-year US Treasury bond, which offers a good snapshot of the entire bond market, has risen from about 1.5 per cent at the end of 2021 to a high of nearly 3.5 per cent earlier this week.

That marks the Treasury bond’s highest yield since 2011. And it is significantly higher than the 1.6-per-cent dividend yield for the S&P 500.

The increase in the bond yield, ending a 40-year market in bonds, has come a surge in inflation multidecade highs and an aggressively aggressive banks response from major central.

The Federal Reserve this week raised its key interest rate by three quarters of a percentage point – its biggest single increase since 1994. Economists expect more hikes this year, not just from the Fed, but also from the Bank of Canada and others.

The Bloomberg US Aggregate Bond Index, which tracks an array of US government bonds, corporate bonds and mortgage-backed securities, is down 12 per cent this year, marking its worst performance going back to 1976.

The problems are not confined to the US market. The iShares Core Canadian Universe Bond Index ETF, an exchange-traded fund that trades on the Toronto Stock Exchange and tracks Canadian bonds, is down more than 14 per cent this year.

No one knows if the selloff is over, yet there are compelling reasons to give bonds a closer look.

“There is a crucial pivot that needs to occur for fixed income to become interesting again,” David Kletz, a portfolio manager at Forstrong Global Asset Management, said in an interview.

The pivot, he said, could come as investors shift their attention from their current fixation on inflation to what comes next. Rising interest rates should slow economic activity and cool off inflation.

“As the focus starts shifting to economic growth, that could actually help pull down bond yields,” Mr. Kletz said.

As bond yields decline, bond prices rise – and it’s not outlandish to bet that this will happen. Inflation and central bank rate hikes appear to be already largely priced into bonds. But the risk of slowing economic activity, if not an outright recession, is not.

An economic slowdown “will prompt inflation to fall, which is what all of this tightening was about. mission accomplished. Now, to help everyone get back on their feet, the rate cuts will begin,” Jennifer Lee, an economist at BMO Nesbitt Burns, said in an e-mail.

The yield on the 10-year US Treasury bond ended the week slightly off its earlier highs, at 3.24 per cent – suggesting, perhaps, that the pivot to this gloomier economic outlook has begun.

Some investors are already moving in on the opportunity here.

Michael Contopoulos, director of fixed income at New York-based Richard Bernstein Advisors, published a note this week in which he argued that financial markets tend to undershoot and overshoot, and today’s bond market is no different.

“Case in point: Investors grossly overpriced Treasuries throughout the previous year and a half, resulting in yields that were way too low. Today, however, investors have moved closer to fair value and, by some metrics, are underpricing Treasuries relative to our estimates,” Mr. Contopoulos wrote.

He believes that if there is a recession within the next two years and the yield on the 10-year US Treasury bond falls back to 1.5 per cent, anyone buying a bond today will see investment gains of 17 to 23 per cent.

“Clearly, the upside/downside has shifted, creating an opportunity for us that we have not seen in a long time,” Mr. Contopoulos said.

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