Outlook 2023: Bonds are back

by Fidelity Viewpoints

After a stormy 2022, the forecast looks bright for fixed income.

Key takeaways

• Bond yields are likely to remain relatively high at least through the first half of 2023.
• Higher yields enable bonds to once again play their historical role as sources of reliable, low-risk income for investors who buy and hold them to maturity.
• Opportunities may also exist in 2023 for managers of mutual funds that regularly buy and sell bonds to buy higher-yielding, lower-risk bonds at attractive prices.
• Professional investment managers have the research, resources, and investment expertise necessary to identify these opportunities and help manage the risks associated with buying and selling bonds when interest rates are likely to change.

In 2022, the Bloomberg Barclay's US Aggregate Bond Index, which represents the vast investible universe of US bonds, is set to do something it has never done before: lose value for the second year in a row.

Bond prices typically fall when yields rise, and as the Federal Reserve raised interest rates quickly and sharply to combat inflation, investors who feared falling prices sold bonds.

However, as 2023 begins, bonds look poised to once again deliver their traditional virtues of reliable income, capital appreciation, and relatively low volatility. For the first time in decades, bond yields are high enough that income-seeking retirees can use them to help support a 4% withdrawal rate from their portfolios.

What’s more, bond funds could also have a comeback, propelled by higher yields, and possibly higher prices if the Fed cuts rates to help the economy come out of a potential recession later in the year.

Why bonds are back

Because bond prices typically fall when interest rates rise, bond markets have long been sensitive to changes in rates by central banks. But they are also influenced by other factors such as the health of the economy and that of the companies and governments that issue bonds. Since the global financial crisis, though, the interest rate and asset purchase policies of the Fed and other central banks have become by far the most important forces acting upon the world's bond markets. In 2022, the focus of their policies shifted from supporting markets to trying to fight inflation and bond markets reacted badly.

The Fed's rate hikes ended the bull market in bond prices that had been running since 1982. But Jeff Moore, manager of Fidelity Investment Grade Bond Fund (FBNDX) thinks a new bull may be ready to charge out of the chute. He says, “I think next year will be a high total return environment for bonds. Unlike a year ago when there were no chances for capital gain, now interest rates are back to almost 30-year norms. Whether you want to build a portfolio with Treasury, municipal, investment-grade corporate, or high-yield bonds, you can get respectable yield and you could do very well if interest rates head back down again.”

Moore says the end of Fed rate increases matters far more for bond prices in 2023 than worries about rising credit delinquencies, the inversion of yield curves (when short-term bonds pay more interest than long-term ones), or the possibility that foreign governments will stop buying US government bonds. “All of those things can vex the markets, but what really matters is whether the Fed stops raising rates,” he says.

The price is nice

Even if their prices don’t rise much in 2023, bonds will still pay interest at rates that are set when they are issued and they will also still have a face value (called “par”) that the bondholder will receive when the bond matures, provided that the bond cannot be called by its issuer. These facts of bond life are especially meaningful for investors who are in or near retirement and are more interested in predictable income than in potential capital appreciation.

That means angst about how interest rates might affect bond prices shouldn't obscure the fact that the return of rates to historically normal levels may present a long-awaited opportunity in bonds for those who seek income and principal protection. For years, as Managing Director of Asset Allocation Research Lisa Emsbo-Mattingly puts it, "The Fed had been financially repressing savers, especially retirees." Now, higher rates mean that retirees and savers may be able to earn attractive returns without taking much risk in 2023 and beyond.

Not only are yields up, prices of many high-quality bonds are down as a result of the 2022 selloff. That means opportunities exist for those with cash to buy relatively low-­risk assets at bargain prices even as they pay yields that are higher than they have been in decades.

Emsbo-Mattingly expects the Fed to continue to raise the federal funds rate further until it has an impact on inflation. If inflation comes down closer to the 2.5% range where the Fed wants and expects it in 2023, real rates, which are bond yields minus the rate of inflation, could rise further into positive territory. This would help high-quality bonds to once again be meaningful contributors for many retirees who are looking to supplement Social Security, pensions, and other sources of income.

How long will this go on?

The opportunities provided by higher rates could be short-lived. Getting inflation under control is the focus of Fed policy in the months ahead, but the central bank also wants to make sure it has room to cut rates if the economy goes into recession, potentially in 2023. Rate cuts are the most powerful tools the Fed has to stimulate economic growth and the central bank wants to be able to make impactful cuts when necessary. That could mean that the opportunity to add low-risk, high-yielding bonds to your income strategy may not be there if you wait too long.

More fun for funds

While 2023 may be a great time to buy, hold, and ladder bonds, the outlook is also bright for investors in funds that manage bonds with an eye to making money as prices rise. Moore says he has bought more bonds with longer maturities than he did in 2022. “I have bought 10-year Treasury bonds and 10-year bonds from good quality companies because they were yielding 5% to 7%. Even if you feel like there's a recession coming, these should be fine.”

Moore believes that market conditions as 2023 starts are similar to 2019 and 2020 when bond indexes returned almost 10% after a big drop in 2018. “We had a great big drawdown earlier in 2022 but since then, the bond markets have returned 5.5%, and there are scenarios where things could go very well. If you just want to build a bond ladder for reliable income, that’s great, but if you care about capital appreciation, you could be kicking yourself for overlooking bond funds if they deliver double-digit return in any of the next 1 or 2 years.”

Finding ideas

If you’re interested in adding bonds to your portfolio, you can choose from individual bonds, bond mutual funds, and exchange-traded funds as well as separately managed accounts (SMAs).

Funds and ETFs offer exposure to the ups and downs of markets where prices change on a daily basis. When interest rates rise, bond fund and ETF prices tend to fall. But when interest rates begin to fall and bond prices rise, bond fund and ETF holders have the potential to benefit.

For retirees and other income seekers who are willing to hold individual bonds to maturity, rising rates can be a good thing. For the first time in decades, it’s now possible to generate a reliable flow of income by arranging low-risk, high-quality bonds of varying maturities in a ladder.

If you're considering individual bonds, you should know that the bond market is large and diverse and getting the best prices can be tricky. Fidelity can help by offering a wide range of ways to research bonds as well as professional help to construct a portfolio that reflects your needs, your tolerance for risk, and your time horizons.