Why fixed income continues to claim its rightful place during rate cuts

We’ve shared a lot about the opportunities in fixed income investing during periods of high interest rates. But what happens when rates start to drop — do those opportunities still exist? Until recently, bonds and other fixed income investments were likely absent for some time in the context of a well-balanced investment portfolio. Near-zero interest rates and extremely small risk premiums eliminated many of the factors that make fixed income an attractive part of a well-balanced investment portfolio. But today, fixed income is back in its rightful place and proving its worth against short-term spikes in market volatility. 

The two key elements that are the most attractive to fixed income investors are income generation and a hedge against riskier parts of an investment portfolio. These elements were nearly impossible to fulfill in a zero-interest rate world. And while it was painful to get to where we are today, fixed income now offers both attractions for investors. 

Despite initial cuts in policy rates from the Bank of Canada and with the first U.S. Federal Reserve rate cut likely on the horizon, yields in fixed income markets remain extremely attractive relative to history. According to Bloomberg, as of July 31, 2024, Canadian bonds between 1 to 5 years offered investors an all-in yield of 4% — that’s a full percentage point above the 25-year average of 3%. 

That’s also nearly 2% above the average yield available after the global financial crisis (GFC) in 2008 to 2009. Although potential continued rate cuts will bring yields lower, fixed income investors are seeing some return potential realized with falling interest rates. 

Given yields now have room to drop, fixed income investments also offer a hedge against market volatility in riskier parts of an investment portfolio. In 2022, this relationship failed because near-zero interest rates left bond yields nowhere to go but up. However, more recent bouts in market volatility have shown fixed income investments’ reclaimed ability to hedge, as fears of economic slowdowns trigger selloffs in riskier assets. The S&P 500 lost 6% in the first three trading days of August, while Treasuries posted gains of 2%. Volatility in the early trading days of this month is real-time proof that fixed income investments, such as bonds, continue to benefit as rates are expected to continue lowering. 

Bonds are clearly reclaiming their rightful place in well-balanced investment portfolios and we’re glad they’ve showed up.