Thoughts in Charts: How the Outlook for Bonds Differs in 2023

The bear market in bonds last year was a shock to markets and raised questions around the role of fixed income securities in portfolios. This is because, until 2021, inflation had been steadily falling for 40 years, pushing interest rates lower and bond prices higher. This period supported the idea that bonds act as a stable foundation to portfolios, counterbalancing the price swings in stocks and other riskier assets. Naturally, with stocks and bonds both falling last year, many investors may be wondering if they need to rethink the role of fixed income in their portfolios. As is often the case, it’s important for investors to maintain a longer-term perspective on recent events.

Bonds have had a positive start to the year

While it’s far too soon to say with certainty, this year is already shaping up to be different and few economists and investors expect interest rates to jump as much as they did last year. In fact, it’s been the opposite – after peaking above 4.2% last October, the 10-year Treasury yield has been falling.

This is in large part because inflation is moving in the right direction. Last week’s Consumer Price Index data showed that overall inflation declined in December by -0.1% month-over-month, or an annualized rate of -0.9%. Core inflation, which excludes food and energy, is still rising but the pace has slowed over the past several months. Components such as new and used vehicles are experiencing significant price drops and improving rents may help shelter costs as leases roll over.

So, while consumer prices are still 6.5% higher compared to the year before, this is a backward-looking number since many price categories are improving. The recent reversal has allowed interest rates to ease and increases the likelihood that the Fed will pause its rate hikes later this year, brightening the economic outlook.

This helps long-term investors because interest rates and bond prices are two sides of the same coin. When interest rates rise, bond prices fall, and vice versa.

Bonds generate more income than they have in nearly 14 years

In other words, buying low and selling high applies just as much to bonds as it does to stocks. Today’s bond yields are the highest they have been since the global financial crisis across many major bond sectors. As of January 13, a diversified index of Treasuries yields 3.9% – well above the 1.7% average since 2009, and investment grade corporate bonds generate 5% and high yield bonds 8.1%. It’s now possible for investors to generate income with higher quality fixed income securities, a reversal of the trends of the past 14 years during which investors had to take more risk in order to find sufficient yield.

Where we once considered bonds as having very low expected returns, we now find that we can purchase this lower risk asset with a higher yield than prior averages. For some clients, this allows us to lower risk while pursuing the same return. For others, it presents an opportunity for bonds to start contributing more within the same allocation.

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