Fed Rate Hike Surprises Market Bonds Offer Diversification Amid High Yields

The market's expectation of a US Federal Reserve rate cut in 2026 was shattered when the Fed raised rates on September 16, marking its first hike in over three years. Fed Chair Kevin Warsh emphasized that inflation remained too high, driven by factors like rising oil prices. By early October, the 10-year US Treasury yield had climbed to around 5.3 per cent, its highest level in over two decades. The surprise move highlighted the risks of overconfidence in predicting central bank actions, a costly mistake for investors.

The rise in long-dated yields was not solely due to inflation expectations but also to a wave of debt issuance by tech giants like Alphabet, Amazon, Meta, Microsoft, and Oracle. These companies issued around US$220 billion in bonds by mid-August, a significant increase from the previous year. The influx of long-dated corporate bonds and Treasuries crowded out other borrowers, pushing yields higher. The term premium, the extra yield required to compensate for long-term risk, played a crucial role in this trend.

Despite bonds being one of the most disliked asset classes, historical data shows that high-quality bonds tend to perform well when starting yields are high. Research from Pimco and Vanguard found a strong correlation between starting yields and future returns. With yields around 5 per cent, bonds offer a meaningful cushion against further price declines, making them a valuable diversification tool during equity market downturns.

For Singaporeans, higher US rates present a different landscape compared to previous cycles. The six-month T-bill yield reached 1.92 per cent in late September, still below US yields. Investors should consider currency hedging and the long-term diversification benefits of bonds, especially as they approach retirement. The upcoming CPF investment scheme, set to launch in 2028, emphasizes globally diversified portfolios that shift from equities to bonds over time.