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Why Cautious Investors Should Consider Treasury Bonds

Aug 15, 2023

With solid yields and potential for price appreciation, U.S. government bonds offer a prudent hedge for investors’ portfolios.

Author
Lisa Shalett
Lisa Shalett

Key Takeaways

  • While bullish investors continue to bid up stock valuations, Treasury markets are signaling caution on the economy.
  • Investors may want to consider U.S. government bonds as a hedge against the prospect of a downturn in the stock market.
  • Treasuries are likely trading below their true value and could rebound if the economy slows or the Fed cuts interest rates.

Investors in U.S. equities appear to be reading the market differently from their peers in fixed income.

 

Many U.S. stock buyers still expect that inflation will continue to fall, economic growth will re-accelerate and the Federal Reserve will cut interest rates next year. Meanwhile, Treasury investors appear more cautious: Market pricing signals expectations of a more hawkish Fed and the risk of a bounce-back in inflation.   

 

Morgan Stanley’s Global Investment Committee believes the equity market’s view is too optimistic and that today’s historically rich stock valuations reflect a rosy earnings outlook. We believe the S&P 500 Index is likely to remain in its current range, at best, over the next nine to 12 months.

 

As such, prudent investors should consider ways to protect their portfolios. U.S. Treasuries may be a solid hedge against a potential drop in equity prices, offering decent potential for gains over the current purchase price, as well as coupons (i.e., the annual interest paid on a bond) of around 5%. Here are three reasons why investors should consider Treasury bonds:

 

  1. 1
    The economy likely has yet to feel the full pinch of tighter monetary policy.

    So far, the Fed’s rapid rate hikes have not appeared to meaningfully dent consumer spending and the overall economy, likely due in part to the lingering effects of COVID-era stimulus. However, as that stimulus wears off, household spending and company margins could weaken. An economic slowdown could, in turn, help drive Treasury yields lower and prices higher, especially if the Fed lowers rates next year, as markets expect. 

  2. 2
    The impact of recent challenges to the Treasury market may be overstated.

    Recent developments—including the U.S. credit downgrade by Fitch Ratings and the Japanese central bank’s decision to let interest rates rise more freely—may prove less threatening than headlines suggest. We believe few investors, if any, will view the Fitch downgrade as a reason, on its own, to sell Treasuries. Furthermore, Japan’s lifting of its ceiling on rates by about a half percentage point is likely not enough to meaningfully shift Japanese investors’ appetite away from Treasuries.

  3. 3
    Treasuries appear “oversold.”

    Speculative hedge funds have increased their bearish “short” positions on the bonds to a record level. We have a more constructive view, believing Treasuries are trading below their true value and may be poised for a rebound.

Ultimately, there is a greater prospect for gains in Treasuries than there is for losses. If equity investors are correct and the Fed cuts rates in 2024, Treasury risk is modest, as rates should quickly adjust downward. If that consensus is wrong on growth and the economy slows down, rates are also apt to fall. It’s only if both inflation and economic growth show a surprise increase that Treasuries are at material risk of capital losses.

 

Investors should consider adding intermediate-term Treasuries, balancing exposure in short- and ultra-short maturity positions as the Fed’s hiking cycle matures.

 

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from August 14, 2023, “The Value of Duration.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.

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Index Definitions

S&P 500 Index: The Standard & Poor's (S&P) 500 Index tracks the performance of 500 widely held, large-capitalization US stocks.

Risk Considerations

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

The value of fixed income securities will fluctuate and, upon a sale, may be worth more or less than their original cost or maturity value. Bonds are subject to interest rate risk, call risk, reinvestment risk, liquidity risk, and credit risk of the issuer.

High yield bonds (bonds rated below investment grade) may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk, price volatility, and limited liquidity in the secondary market. High yield bonds should comprise only a limited portion of a balanced portfolio.

Companies paying dividends can reduce or cut payouts at any time.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Investing in small- to medium-sized companies entails special risks, such as limited product lines, markets and financial resources, and greater volatility than securities of larger, more established companies.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies. Technology stocks may be especially volatile. Risks applicable to companies in the energy and natural resources sectors include commodity pricing risk, supply and demand risk, depletion risk and exploration risk. Health care sector stocks are subject to government regulation, as well as government approval of products and services, which can significantly impact price and availability, and which can also be significantly affected by rapid obsolescence and patent expirations.

The indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment.

The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes.  Morgan Stanley Wealth Management retains the right to change representative indices at any time.

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Morgan Stanley Wealth Management is the trade name of Morgan Stanley Smith Barney LLC, a registered broker-dealer in the United States. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy.  Past performance is not necessarily a guide to future performance.

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