Why Bonds Should Do Well In 2023

Bonds have had a nasty 2022, their lousiest year since the launch of what’s now known as the Bloomberg Aggregate bond index, almost a half century ago. Will bonds continue to stink this coming year? Probably they’ll do pretty well, which is good news for investors.

The Bloomberg index, which tracks investment-grade fixed income, is down almost 13% for the year, and at its low in October was off around 15%. The weird thing is that bonds usually don’t lose when stocks are down, which sure has been the case in 2022 with the S&P 500 sliding 20.6%. Who knows what will happen on the equity front in 2023, if indeed the long-anticipated recession finally pounces?

Bonds, however, have a fair shot of returning to their status as the ultimate ballast investment, one that does well in bad times and helps offset the trauma from equities.

This past strange year, the bond market’s nemesis has been the Federal Reserve’s relentless campaign to hike short-term rates to fight high inflation, a situation that’s poison to fixed income. Bond prices drop when rates rise, which accounts for the Agg’s ill fortune of late. Now, though, inflation looks to be ebbing: While it probably won’t dip all the way to 2%, the Fed’s target, it is headed for a tolerable single-digit level.

Thus, the futures market expects the Fed to end its tightening drive, around March, and stay at that point for a while. Few think that the central bank will actually lower rates, unless a really bad recession hits us, but the level its benchmark rate settles at isn’t expected to be much higher than the current 4.25% to 4.5% band.

By mid-year, it should settle at around 5%, according to CME GroupCME
. While that’s a lot more than the near-zero level of a year ago, 5% was the norm in the 1990s, which enjoyed low inflation and high economic growth.

If indeed the Fed pauses next year, bonds should shoot up, writes Lawrence Gillum, fixed income strategist for LPL Financial, in a research note. He says that core bonds—namely investment-grade issues that include Treasury bonds, corporates, mortgage-backeds and agency debt—historically have generated six-month and one-year returns averaging 8% and 13% respectively during these periods. That would go a long way to repairing the damage wrought by the 2022 rate climbs.

Meanwhile, higher rates have had a bright side. The beauty is that you now get relatively great yields from shorter-term bonds, meaning less risky ones. Long-term bonds stick around furhter into the future, when bad stuff can waylay them.

Consider the SPDR Portfolio Short Term Corporate Bond exchange-traded fund, which has investment-grade corporate paper from one- to three-years terms. The ETF has a yield to maturity of 5.7%.

Want even more safety and still-decent payouts? A one-year Treasury sports a yield of almost 4.7%, far better than the 10-year T-note, at 3.9. The lower-maturity government bonds reflect the Fed’s rate hikes ahead, while the 10-year is more subject to market sentiment, which holds that inflation will decrease. Inflation is a bigger worry for longer-term securities.

So maybe that old 60/40 allocation, with 60% stocks and 40% bonds, will no longer be a lose-lose proposition. There’s a comfort in having bonds return to their rightful place in the investing universe.