With 2022 fresh on investors’ minds and with short-term yields at their highest levels in over a decade, it is understandable that some clients are asking whether they should simply sell their bond positions in favor of cash and money market funds. We still believe bonds have a place in a diversified portfolio, and moreover, that the return outlook for bonds has improved markedly over the past 12 months, as we will discuss in this article.
In our view, the presence of a core bond allocation in any diversified investment portfolio continues to make sense in 2023 for several reasons:
- Bonds provide diversification benefits that are difficult to find in other asset classes.
- Bonds are now providing decent income for the first time in more than a decade.
- The total return potential in bonds is relatively high now. An impending economic recession and the prospect of falling rates may lead to an upward repricing of existing bond holdings.
2022 was a brutal year for stock and bond investors alike. High-quality bonds finished the year down 13%, which was better than the -18% return of US stocks but was far from delivering a positive return. In fact, the only major asset classes to end 2022 in the green were cash and commodities, thanks to a Russia-induced oil shock.
Bonds fell so precipitously in 2022 due to the unprecedented speed at which the Federal Reserve (Fed) raised short-term interest rates to combat inflation that had reached a 40-year high. Meanwhile, equity markets sold off as companies reported falling earnings, economic growth declined, and the housing market saw reduced demand thanks to high mortgage rates. The result was a rare instance in which stocks and bonds posted negative returns during the same year. In fact, this “double negative” has only happened 4 times in the last 50 years, as seen in the chart below.
What are we to make of bonds’ poor showing in 2022? Is the asset class broken?
We don’t think so. In fact, we think it would be major mistake to exit bonds in 2023, for several reasons.
Bonds are an essential part of a well-diversified portfolio because they generally do not move in tandem with stocks. Mixing different asset classes together helps investors achieve potentially higher returns over time, with less volatility along the way. In 2022, bonds lost money in absolute terms, but diversification benefits were still present. Bonds lost less than stocks, buffering portfolio returns.
More importantly, though, the case for bonds as a risk management tool for investors has not changed. Both cash and bonds can serve as an important ballast for an investment portfolio. Unlike cash, bonds can deliver total returns consisting of both coupon payments and price appreciation, which they frequently do during periods of equity market turmoil. Generally, when investors become concerned about economic conditions, they invest into safe-haven assets like U.S. Treasury securities, which tends to put downward pressure on bond yields, leading to increasing bond valuations.
The net result? Bonds can do more than simply serve as portfolio ballast during periods of stock market volatility; they can deliver positive total returns and offset some of the losses on the equity side.
2. Competitive Yields
The interest rate environment has changed drastically over the past year. Short-term fixed income rates were barely above 0% coming into 2022, and now they hover around 4.30%, due to the Fed's multiple rate hikes throughout the year. Higher interest rates have driven bond yields higher, giving bond investors the opportunity to generate meaningful income for the first time in more than a decade.
As of December 31, 2022, high-quality bonds were yielding 4.7%, just slightly above money market funds. The yields for some bond sectors, however, were meaningfully higher. For instance, US high yield bonds yielded 9.0% at year end, and emerging markets debt yielded 8.6%.1
Now can potentially be a good time to be an income-oriented investor, since income opportunities are plentiful in fixed income products of all types.
3. Total Return Potential
For investors using mutual funds and ETFs to gain exposure to bonds, rising rates in 2022 meant negative total returns. However, as rates remain at these higher levels, the underlying bonds in their portfolios can be reinvested at higher yields, boosting portfolio income, which is the primary driver of bonds’ total returns over the long term.
In the near term, bond prices will fluctuate due to changes in interest rates and credit spreads (the yield premium of a corporate bond in relation to a Treasury bond of a similar maturity). Weakening economic conditions and moderating inflation could spell an end of the Fed’s rate hikes, which would be a positive for bond prices.
Has inflation peaked? It appears so, at least in the short term. The year-over-year change in the consumer price index (CPI) reached 9.1% in June 2022 and fell to 6.5% at year end. This is still above the Fed’s long-term inflation target of 2%, but it seems that inflation is trending downward. Bond markets are also expecting inflation to continue moderating, as indicated by 5-year inflation breakeven rates (the yield difference between TIPS and nominal bonds) of just 2.2% as of February 2, 2023. 2
Treasury futures indicate that markets believe the Fed has neared a peak in its rate hiking efforts. A shift in Fed policy could support bond prices, adding to total returns for investors.
4. Historical Trends
Finally, history indicates that 2023 could be a promising year for bonds. During the last 50 years, there have only been three other occurrences during which both equities and fixed income were down in the same year.
Of those three years (1974, 2008, 2018), the following years produced double digits returns for both categories. There have never been two consecutive years wherein both equities and fixed income finished in the red.
In short, we are optimistic about the short-term prospects for bonds. Moreover, we think they serve an important role in investor portfolios that has stood the test of time. While we encourage investors to ensure their cash investments are positioned to take advantage of attractive short-term rates, we believe long-term investors are best served by maintaining a core bond position in their portfolios. As always, you should discuss bond and other diversification strategies with your advisor as part of your overall financial and investment planning.
A diversified portfolio does not assure a profit or protect against loss in a declining market. The return and principal value of bonds fluctuate with changes in market conditions. If bonds are not held to maturity, they may be worth more or less than their original value.
The views stated are not necessarily the opinion of Cetera Advisor Networks LLC and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.
1 Source: JPMorgan Guide to the Markets, 12/31/2022
2 Source: Federal Reserve Bank of St. Louis
3 Returns based on the Bloomberg US Credit TR USD Index