January 31, 2023

The path and pace to higher interest rates in 2022 and its impact on the bond market was like a steep and strenuous climb for even the most seasoned hikers. Setting out from the valley floor, at the lowest interest rates in history, the terrain grew quickly and increasingly challenging as the Federal Reserve’s actions drove an unexpectedly sharp incline. While the trek to tighter monetary policy is not yet over, the ascent is finally beginning to moderate as peak rates appear to be on the horizon. Given significantly higher yields today, bonds now offer compelling opportunities and are likely to return to their traditional role of providing reliable income and sensible ballast in a portfolio.

Even though the consensus view heading into 2022 was that interest rates would rise, the magnitude and pace of rate hikes nonetheless stunned the markets. Contrary to the Fed’s December 2021 forecast of only about 1% of rate hikes in 2022, it instead raised rates by an eye popping 4.25% over the course of just 10 months. Moreover, this aggressive rate-hiking strategy was adopted by many central banks around the world to combat persistently high inflation. Globally, central banks delivered a staggering 280 rate hikes in 2022—enough for one rate hike every trading day of the year. It was the most aggressive year for interest rate hikes in four decades, and as a result, fixed income performance was particularly challenged.

The silver lining to this front-loaded rate-hike cycle is that bond yields are now at their highest levels in over a decade, offering investors more income and better potential total return outcomes going forward. If we look at the Fed’s December 2022 forecast—with estimates written in pencil rather than permanent marker given the ongoing revisions—it anticipates rates will peak around 5% and inflation will return to around 3% this year. Even if these figures get revised, the vast bulk of rate hikes and peak inflation are likely behind us. These two factors are significant and lend support to the outlook for better bond performance ahead.

Another benefit of the dramatic repricing in bonds is that risk-return tradeoffs have improved, and investors no longer must push the risk spectrum to find income. This is a dramatic change from just two years ago when around 25% of the investment-grade global bond market traded at a negative yield. For the first time in almost a decade, we can celebrate the absence of negative yielding bonds. Inflation-adjusted real yields are also beginning to look more attractive as inflation normalizes.

As of December 31, 2022, yields across the bond market range from about 4.5% on 1-year Treasuries, to 5% – 7% on intermediate investment-grade bonds, and double digits on riskier high-yield bonds. Tax-free municipal bonds look particularly attractive given relatively healthy state and local government finances with starting yields of up to 3.5% on intermediate high-quality bonds, which are the tax equivalent of high single digits depending on one’s tax bracket. Overall, in the current environment, we prefer a tilt towards quality with some limited tactical exposure to higher yielding bonds for the yield enhancement.

The substantial reset in bonds likely means that their diversification benefits are back. After a particularly challenging year where both stocks and bonds declined, we look for bonds to provide solid capital preservation. The additional yield cushion makes bonds less vulnerable and provides investors with steady, predictable income. Long-duration safe-haven bonds such as Treasuries tend to do well during periods of economic uncertainty and can also help mitigate the effects of more volatile assets. Investors can benefit from owning a combination of different types of bonds, offsetting credit with longer-term Treasuries where investors can benefit from price gains in a weak economy. While the dramatic 2022 repricing of bonds was a painful moment for investors, conditions are unfolding that could bring more constructive outcomes in 2023. Dislocations mean opportunity, and while volatility is likely to remain elevated, we see attractive entry points across the bond market and reasons to be optimistic in the months to come.

_{Sources: Federal Reserve, U.S. Department of the Treasury, J.P. Morgan, Financial Times}