Falling inflation alongside a cooling economy has bond investors feeling relieved: The Federal Reserve may finally be done lifting interest rates. And with yields across bond markets near 20-year highs, bonds could be the comeback story of 2024.

Investors have been here before — only for the central bank to continue to raise rates as inflation didn’t slow quickly enough. “The difference this time compared to the past year is a combination of inflation falling much closer to target and many more data points showing that high interest rates are taking a toll on the economy,” says Oliver Edmonds, a Capital Group portfolio manager.

The Fed has kept rates steady for several months after raising them since March 2022 to the current range of 5.25% to 5.50%. Officials signaled three rate cuts and intend to lower borrowing costs to 4.6% by the end of 2024.

Meanwhile, employment and consumer spending have remained surprisingly resilient. The unemployment rate hovered at 3.7% in November, with 199,000 jobs added. That rate is above the 50-year low of 3.4% that the U.S. hit in April 2023.

“The lifeblood of the economy is the consumer, who is supported by full employment. Once you see employment figures declining past a certain point,” Edmonds adds, “it can easily spiral, and you can end up in a situation where the Fed has overtightened.”

That point — according to one recession indicator known as the Sahm rule — is when the three-month unemployment average is 0.5% point or more above its low in the prior 12 months. The current value is 0.3% point.

A positive outlook on interest rates

When the Treasury yield curve inverted — meaning short-term yields moved higher than long-term yields — in July 2022, many viewed it as an alarm bell for an imminent recession. More than a year on, a recession has not materialized, but it is still too early to tell whether the Fed managed to pull off a “soft landing,” believes Tim Ng, a Capital Group portfolio manager.

Historically, the average time frame for a recession following an inverted yield curve has been about 15 months, with the longest interval being 24 months. Moreover, the Fed’s rate hikes will continue to be felt as they filter through the economy. In response to the uncertainty, bond markets have seesawed between the belief that the Fed will keep rates higher for an extended period and they will cut interest rates in 2024 to avoid deep economic damage.

Under both scenarios, investors may want to position for a normalization or steepening of the yield curve, where long-term Treasury yields are higher than short-term yields, says Ng, a member of Capital Group’s U.S. rates team. “The yield curve is likely to steepen in a recessionary environment and could also steepen in a higher-for-longer environment where short-term yields remain anchored while longer term yields rise.”

Current valuations may offer an attractive entry point as the interest rate outlook is more benign. “Further curve inversion is likely limited and would require a reacceleration of inflation, which we consider a low probability,” Ng adds.

Prices have declined for several categories in the Consumer Price Index (a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services), including used cars and trucks, hotels and airfares. Meanwhile, fewer categories have outsized price increases. These trends should continue, while further loosening in labor markets may lead to a sustained cooling in wage growth. The Fed could feel less pressure to keep rates high and may lower its policy rate if it is perceived to be too restrictive given the level of inflation.

The point in the cycle when the Fed is done hiking rates has tended to be an attractive time to own duration, which measures a bond’s sensitivity to interest rates, and is a hallmark of bonds with longer maturities. “If you study the end of rates cycles in the U.S., these periods have been generally positive for fixed income and for duration,” Ng says.

Mortgages and investment-grade bonds offer compelling opportunities

Despite an uncertain economic outlook, high starting yields combined with a confluence of supportive factors currently underpin agency mortgage-backed securities (MBS) and investment-grade corporate bonds (rated BBB/Baa and above).

Over the past few years, there were periods when valuations for higher coupon mortgages were especially attractive, according to Edmonds. Most notably, the regional bank crisis early in 2023 caused yield spreads over Treasuries to dramatically widen before ultimately narrowing as it became clear the economy could withstand the shock of the crisis.

“The narrative for mortgages flipped from being unattractive to being attractive fairly quickly, so it’s about seizing opportunities as they arise,” Edmonds says.

Looking into 2024, the impact of a continued runoff of the Fed’s balance sheet may become a more prominent topic, as the central bank has been price insensitive and the largest buyer of mortgage securities over the last few years. Nevertheless, housing inventory and affordability remain near all-time lows, which will continue to reduce the supply of mortgage securities and, in turn, support valuations.

“As securities that carry an implicit government guarantee, agency MBS can be an outstanding way of adding income to a portfolio without taking credit risk that correlates with equities and other assets,” says David Betanzos, a Capital Group portfolio manager.

Meanwhile, investment-grade corporate bonds are supported by strong balance sheets and low refinancing needs. In a modest growth environment, investors could earn the coupon payment without too much downside risk. If the economy slows and Treasury yields decline, the sector’s longer duration relative to other credit sectors such as high yield would mean potential price appreciation, which could offset any widening in spreads.

Overall, investment-grade corporate bonds can provide a solid middle ground for portfolios. If the Fed executes a ”soft landing“ and avoids a recession, investment-grade credit should fare well. And if there’s a recession, the drawdown, or peak-to-trough decline in returns, should be muted compared to what would be expected in other areas of credit, especially lower rated bonds.

Many investment-grade-rated companies won't face pressure to issue new debt until interest rates come down as they used the pandemic era’s low interest rate environment to lock in financing at attractive rates with long maturities. Therefore, supply will likely remain muted even as demand from investors such as pension funds, banks and insurance companies continues.

A balanced approach to emerging markets debt

Emerging market (EM) local currency bonds are less vulnerable to higher developed market rates than previously. Many EM economies have seen improving economic trends. “On balance, the fiscal deficits of several EM countries have narrowed to or below pre-pandemic levels,” says Kirstie Spence, a Capital Group portfolio manager. Meanwhile, as inflation has been declining, EM central banks are starting to cut interest rates. Falling EM rates alongside decent fundamentals should support EM local currency bonds in 2024.

The hard currency, U.S. dollar-denominated bond market is divided between issuers rated investment-grade and high yield. Spreads on some higher yielding, lower credit quality EM bonds have trended wider, but are being driven by factors specific to each credit, requiring case-by-case analysis. Many investment-grade credits offer lower income but are supported by relatively strong fundamentals.

Spence favors a balanced approach to owning both hard and local currency issuers: A blended portfolio can benefit from the differentiated risk profiles and return drivers for each segment of the market. Historically, two-year forward returns have been positive when yields reached 6.7% or higher. High starting yields offer a buffer against any volatility that the global macroeconomic and geopolitical environment might bring in 2024.

Municipal bond fundamentals appear solid in uncertain environment

Rising yields have dampened municipal bond returns over the past few years. The silver lining? Solid income opportunity. The Bloomberg Municipal Bond Index (“Muni Index”) yielded 3.6% as of November 30, 2023. Investors can often also benefit from munis’ tax-exempt status. That advantage over taxable bonds starts at federal tax rates as low as 29%.

Robust state coffers suggest strong fundamentals. Corporate income and general sales tax receipts continue to climb. Household income remains near the historic high, despite some layoffs and cooling wage growth.

While munis have shown resilience during periods of economic turmoil, a defensive stance may be warranted. ”I’ve positioned the funds I manage to benefit if the inverted muni yield curve — a historic anomaly where short-term yields are higher than longer term yields — normalizes,” says Vikas Malhotra, a Capital Group portfolio manager. Companies providing essential services, such as electrical utilities, are also attractive in a slow-growth environment.

Other compelling opportunities include planned amortization class (PAC) bonds, which are pooled single family mortgage loans backed by the federal government. PAC bonds contained in the muni index yielded 4.3%, compared to 3.1% for the index’s broader five-year subset (a similar maturity profile), as of November 30, 2023. Meanwhile, given rising wage pressures, some managers are more cautious on hospitals.

Back to basics

The Fed is likely done with interest rate increases. While the economy has held up so far and inflation has fallen from its peak, the full effect of the tightening campaign is still being felt and the U.S. is not out of the woods.

The end of the hiking cycle means bonds may soon return to the basic roles of providing income and diversification from equity market downturns, says Edmonds. “It’s been a volatile few years for bond investors, but we’ve reached a turning point in the Fed cycle where rate cuts may be coming in 2024, which would be a tailwind for bond returns. Even without cuts, income potential is still a possibility.”