What will make long-term bonds attractive again? Recession, say some

Investors yearning for the day when long-term bonds again become attractive investment vehicles will have to wait a while longer, money managers say. And when that day arrives probably hinges on whether or not the economy dips into recession.

Long-term bond yields have suffered as the Federal Reserve bumped up interest rates and it’s looking more likely that the Fed will inch up rates again next month, further depressing bond yields, experts say. The vaunted bond yield curve, which tracks the return gap among short and long-term bonds has been unusually inverted for some time. Three-month treasury bonds at the moment might return 5.25% while 10-to 30-year bonds are yielding between 3.7% and 3.9%.

“The markets now are pricing with a 50-50 chance of a hike in the Fed funds rate in July,” said Donald Ellenberger, senior vice president and senior portfolio manager of Multi-Sector Strategies Group at Federated Hermes. “So that has certainly hurt bonds, as longer-term bonds have all that duration risk and they’ve lost total value.”

The curve will have to “dis-invert,” investors say, before long-term bonds are attractive again.

“We are clearly entering a tricky phase over the remainder of this year, with weak growth, higher financial risks, and no clear sign yet that core inflation is coming down,” said  Bill Thornhill, cover bonds editor at GlobalCapital, a leading news, opinion and data service covering the international capital markets. “On the other hand, banking turmoil should mitigate the need for tighter policy. But a premature abandonment of the fight against inflation would have the opposite effect. Tighter fiscal policy could help cool the economic activity and support monetary policy so there’s a lot of things in the mix.”

The experts point to two scenarios that will have the utmost impact on long-term bonds. Both involve the “R” word.

In the first scenario, the economy manages to avoid a recession and long-term bonds continue to fall out of favor.

“If there is not a recession, I think you probably want to avoid longer term bonds,” said Ellenberger. “Because in that case the Fed has no reason to cut rates, so you’ll continue to get 5.25% for T-Bills. If the Fed keeps rates high, we’ll probably have a negative return on longer-term bonds.”

In scenario number two, the economy does indeed slip into recession and, as strange as it may seem, long-term bonds may become an investment of choice. A recession will likely set off an investor “flight to quality,” in which they eschew more risky investments like high yield bonds, emerging market bonds, bank loans, or even stocks, in favor of the safety of T-bills and, yes, long-term bonds, which might provide a better total return over their duration.

“If the Fed eventually induces a recession, rate cuts would be in order,” said Dave Novosel, senior analyst, telecommunications, media and technology for Gimme Credit, a New York-based independent corporate bond research organization. “That would make the long-term bonds attractive again.”

It all depends on the course of inflation, as bond investors wait on the sidelines, Novotel said.

“Unfortunately, the longer it takes to reach the Fed’s goal [of 2%], the more imbedded it becomes in the minds of consumers,” he said.

Which scenario seems more likely depends on whom you ask. But the consensus seems that predictive indicators are pointing to a mild recession hitting sometime late this year.

The inverted yield curve, itself, has traditionally been a good predictor of a coming recession. The index of leading economic indicators have been negative for 13 consecutive months, which is another tip off of impending recession.

“Every recession in recent memory has been preceded by a drop in corporate profit margins,” said Ellenberger, “and they’ve now declined for two quarters in a row.”

Banks are tightening lending standards and regulators seem to be unwilling to raise capital requirements for banks which may bring on a credit crunch. Money supply growth is contracting at the fastest pace since the 1930s, which also isn’t helping the economy break out of its doldrums.

“One last thing we look at and that’s always been a good recession indicator for us is consumer expectations,” said Ellenberger. “And right now, consumer expectations for the future are far, far more pessimistic than they are for today. And when you see that kind of big gap, whenever people think things are going to get worse, that’s usually another good predictor that recession risks are rising. So, all these different indicators that we look at, tell us recession risks are high and rising.”

And that, Ellenberger said, means there will actually be some value in long-term bonds.

Other caution that long-term corporate bonds can be risky in any scenario.

“The bond market is not very good at distinguishing between risks of different horizons,” said John Hay, corporate finance and sustainability editor at GlobalCaptial. “If you take the great U.S. tech companies right now, they are very highly rated at the moment, with good credit risks and high ratings.  But when they issue a 20-, or 30-year bond, do we really think that the tech environment, which has changed beyond all recognition in the past 20 years, is going to not change in the next 20? Will the Apples, Microsofts, and Googles still be top of the pile? That seems an almost foolhardy assumption.”

Doug Bailey is a journalist and freelance writer who lives outside of Boston. He can be reached at doug.bailey@innfeedback.com.

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