• Why are bonds a great investment.
• Are rates going down?
• Why long-duration bonds?

To grasp the significance of the current moment as a potential opportunity to either enhance bond exposure in portfolios or acquire bonds for the first time not only for income but even more so for the potential capital appreciation.

Bond prices and interest rates share an inverse relationship. Bond prices tend to decline when interest rates are low and experiencing an upward trend. Conversely, bond prices tend to rise when interest rates are high and on a downward trajectory.

So, are rates going lower?

As we approach the end of the hiking cycle, the disinflationary trend likely remains well-established. The Consumer price index (CPI) dropped to 4.0%, as May marked the 11th consecutive month of slower year-on-year inflation. Not only that, but the inflation index is crashing quicker than it rose after it peaked at 9.1% only 11 months ago; it fell with pretty much the same lightning speed at which it climbed.

Even the sticky components have started to roll over, most notably shelter inflation (which accounts for over a third of the index) tumbled twice in the past two reports, from 8.2% in March (highest since 1982) to 8.0% in May. A continued move lower in Shelter inflation will significantly impact overall CPI as the money supply continues to tumble and the various inflation measures with it.

And with inflation continuing its hellish descent, some market players such as Credit Suisse are now expecting a further CPI nosedive for the June report to 3.2% YoY.

The US economy can’t handle high rates.

This hiking cycle rates have skyrocketed 5% lightning fast, in just 15 months to the highest level since June 2006. That has spelled problems for many financial institutions. The corporate sector feels the heat from nearly 500 basis points increases this cycle. Bankruptcy filings are being made at the fastest pace in over a decade. Over the first five months of the year, there have been 286 corporate bankruptcies, the highest total since 2010, according to S&P 500 Global.

The narrative around rate cuts shifts from one relating to recession/bank contagion to one where the Fed moves from a less restrictive stance, given the progress on inflation, to accommodative by year-end.

Now that we’ve established why fixed income looks attractive. Why Long the long end of the yield curve? For the potential price appreciation, just a 1% rate decline would produce a whopping 23.8% capital appreciation for 30-year bonds, as visible from the graph below.

That comes from the duration effect – the long end of the yield curve benefits more over the short end, from price appreciation when rates fall . That’s because higher-duration bonds are more sensitive to changes in interest rates.

Let’s illustrate this with a real-world example. Look at the decline in the TLT ETF (20Y+ Treasury bonds) from the end of 2021, when inflation turned out not to be “transitory”. As it was nearing 5%, it was apparent that the Fed would have to embark on a massive rate hike cycle to slay the inflation beast. The ETF dropped over 40%.

The TLT, currently just over 102 is way below its mean value of 127.52; as soon as market participants wake up to the idea that the economy is cracking and deflation becomes the biggest tail risk the market is facing, it can break that consolidating channel to the upside as it mean-reverts.

If history is any guide, following periods of bond market declines (such as 2022 and 2021), subsequent years often yield great risk-reward returns, combined with the potential massive interest rate cuts means that the time for bonds is now.