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How the Outlook for Bonds Differs in 2023

Last year's bond bear market was a shock to markets and prompted inquiries on the significance of fixed income products in portfolios. This is due to the fact that inflation had been declining steadily for forty years prior to 2021, pushing interest rates down 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. After a year in which both equities and bonds declined, many investors may be asking if they need to reconsider the importance of fixed income in their portfolios. As is typically the case, investors must keep a longer-term perspective about recent developments.

The beginning of the year has been favorable for bond investors.

While it is far too early to predict with certainty, this year is already shaping up to be different, and few economists and investors expect interest rates to rise as much as they did last year. In fact, the 10-year Treasury yield has been falling since peaking above 4.2% last October. 

This is due in large part to inflation moving in the right direction. According to the Consumer Price Index data released last week, overall inflation fell by -0.1% month over month in December, for an annualized rate of -0.9%. Core inflation, which excludes food and energy, is still rising, but at a slower pace in recent months. Components such as new and used vehicles are seeing significant price drops, and rising rents may help with shelter costs as leases roll over.

So, while consumer prices are still 6.5% higher than the previous year, this is a backward-looking figure because many price categories are improving. Treasury Inflation-Protected Securities (TIPS) are now priced with the expectation of only 2.2% annual inflation over the next 5 to 10 years. Inflation is a scourge on bonds because higher consumer prices cause investors to demand higher interest rates. The recent reversal has allowed interest rates to fall and increases the likelihood that the Fed will pause rate hikes later this year, brightening the economic outlook. 

This benefits long-term investors because interest rates and bond prices are two sides of the same coin. Bond prices fall when interest rates rise and vice versa. One intuitive way to think about this is that the lower the cost of a bond with a specified payout schedule, the higher your eventual return, or yield. Thus, another way to look at last year's drop in bond prices is that bond yields are now much more appealing.

Income from bonds is higher than it has been in almost 14 years.

In other words, the maxim of "buy low, sell high" is equally applicable to bonds and stocks. Bond yields are at their highest levels since the global financial crisis in the majority of major bond sectors. The yield on a diversified index of Treasuries is 3.9%, far higher than the 2009 average of 1.7% Investment-grade corporate bonds yield 5%, while high yield corporate bonds yield 8.1%. It is now possible for investors to create income with higher quality fixed income assets, reversing the pattern of the past 14 years, during which investors were required to take on greater risk in order to generate sufficient yield.

Credit spreads and corporate bond yields have both improved.

In addition, the outlook for credit remains optimistic despite a possible slowdown in the economy and earnings growth. In recent months, credit spreads have actually improved as economic indicators, particularly the job market, have remained robust and the likelihood of a pause in Fed tightening has increased. Even if there is a recession, the markets anticipate that it will be mild and that companies will still be in a position to repay their debts. 

Obviously, the year is still young, and there are always risks to consider. A protracted fight in Washington over the debt ceiling could again threaten the bond market, as it did in 2011 when Standard & Poor's downgraded the United States' debt rating. If geopolitical conflicts deteriorate, commodity prices may increase and supply chains may be disrupted. In the event of a worse-than-anticipated economic downturn or a spillover of international weakness into the United States, credit default rates could rise.

As is always the case, investors must accept these risks without compromising their financial objectives. Buying and holding bonds at these prices and yields is not a short-term investment strategy, but rather one designed to position portfolios for the coming years and decades. 

Despite the difficult outlook for bonds in 2022, investors should maintain a suitable allocation to fixed income as interest rates stabilize and bond prices recover.