2023: A Better Year for Bonds?

Chris Keith

Senior Vice President, Fixed Income Manager

As a bondA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. investor, the best thing I can say about 2022 is that it’s over! And we believe 2023 will be a better year for bondsA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates..

After years of artificially low interest rates, the days of reckoning came in 2022. First slowly, with one rate hike of “just” 25 basis points. Then the onslaught—four consecutive rate hikes of 75 basis points each, bookended by a pair of 50s. All told, there were seven rate hikes in 2022—raising the fed funds rate by 425 basis points.

When all was said and done the U.S. bond market had its worst calendar year on record in 2022, down 13%.

The culprit is no surprise: The highest level of inflation since the early 1980s called for decisive action from the Federal Reserve. Debating whether Chairman Powell & Co. should have acted sooner or done something different isn’t going to change the outcome—bonds’ loss of market value took many by surprise. The next logical question is where do we go from here?

We believe 2023 will be better for bond investors. Among the reasons for our optimism:

• Inflation is moderating
• Fed rate hikes seem to be stepping down
• High-quality bonds offer more yieldYield is a measure of the income on an investment in relation to the price. There are several ways to measure yield. The current yield of a security is the income over the past year (either dividends or coupon payments) divided by the current price./income today than they have in well over a decade
• There’s a risk-free option that earns an acceptable rate of return

Let’s look at each of these in turn.

Inflation is moderating. We didn’t endure all that pain last year for nothing. After peaking at 9.1% in June, the consumer price index (CPI) fell to 7.1% by November. There’s still a very long way to go before we’re back to 2%–3%, but we are on our way to a disinflationary environment. (By that I mean a lower rate of inflation, not all-out deflation.)

Fed rate hikes seem to be stepping down. The Fed’s most recent rate hike is lower than the previous four, and softening inflation reports indicate that the rate hikes of 2022 are starting to do their job. In fact, the Fed’s downshift (from 75-basis-point hikes to 50) speaks volumes. And we may be looking at 25 basis points later this month.

High-quality bonds offer more yield/income today than they have in well over a decade. BondA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. yieldsYield is a measure of the income on an investment in relation to the price. There are several ways to measure yield. The current yield of a security is the income over the past year (either dividends or coupon payments) divided by the current price. are beginning the new year at vastly more appealing levels than a year ago. Higher yields mean more income—and income has historically been the biggest driver of returns (including bond funds and ETFsA type of security which allows investors to indirectly invest in an underlying basket of financial instruments (these may include stocks, bonds, commodities or other types of instruments). Shares in an ETF are publicly traded on an exchange, and the price of an ETF’s shares will fluctuate throughout the trading day (traditional mutual funds trade only once a day). For example, one popular ETF tracks the companies in the S&P 500, so buying a share of the ETF gets an investor exposure to all 500 companies in the index.) in fixed income.

There’s a risk-free option that earns an acceptable rate of return. For fixed-income investors who seek a risk-free option with an acceptable locked-in rate of return, your option is here courtesy of the very same Fed (and rate hikes) that wreaked havoc in 2022. A one-year U.S. Treasury is beginning 2023 yielding 4.67% vs. 0.37% a year ago. We’ve come a long way.

While I believe the coming year will be better for bond investors, there are risksThe probability that an investment will decline in value in the short term, along with the magnitude of that decline. Stocks are often considered riskier than bonds because they have a higher probability of losing money, and they tend to lose more than bonds when they do decline. that could derail a rebound. For instance, a reversal of the current trend of slowing inflation could emerge—sparked, say, by either domestic or global events. Even if inflation simply flatlines from here, it’s still too high and may push the Fed to reinstate a more aggressive posture.

But from where I sit, the fixed-income landscape is in a better place, and demand for high-quality, income-producing assets remains strong. As such, I remain optimistic.