Winter is over. Bonds are back.

by Fidelity Viewpoints

Investment-grade fixed income has rediscovered its old strengths.

Sometimes it snows in April, but for bond markets, winter is over. After an unprecedented deep freeze during which investment-grade bonds lost value for 2 years in a row, the Bloomberg Barclays Aggregate Bond Index, which represents the vast, investible universe of US bonds, is up so far this year. That recovery, though, is only a reminder that the cycle of the seasons continues, despite fears—or wishes—to the contrary. Bond prices have historically never failed to recover after losing years, so this year’s recovery is not unexpected.

Jeff Moore manages the Fidelity Investment-Grade Bond Fund (FBNDX) and he believes that the rise in prices of investment-grade bonds so far in 2023 heralds a new era of opportunity for investors who previously felt they had little choice but to either brave the volatility of stocks, or to hide in cash and let inflation rob them of their savings. "Bonds are once again doing what they have historically done: delivering income while helping protect the value of investors’ portfolios from the ups and downs of the stock market," he says.

If you are looking for reliable income, now can be a good time to consider investment-grade bonds. If are you looking to diversify your portfolio, consider a medium-term investment-grade bond fund which could benefit if and when the Fed pivots from raising interest rates. Says Moore: “I think the next 2 years could be a high total return environment for bonds.”

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 have ended the bull market in bond prices that had been running since 1982. But Moore thinks a new bull may be on the horizon. He says, "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 actions of the Fed matter far more for bond prices 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.

A recession-ready investment

While bonds may appear attractive as the long-term investment climate changes, they also may offer investors an attractive strategy for helping manage through a potential recession in the near future.

Recessions are times when economic activity contracts, corporate profits decline, unemployment rises, and credit for businesses and consumers becomes scarce. Recessions are not happy times for investors. During the 11 recessions the US has endured since 1950, stocks have historically fallen an average of 15% a year.^*

But bonds have historically thrived when the economy has contracted. In every recession since 1950, bonds have delivered higher returns than stocks and cash. That's partly because the Federal Reserve and other central banks have often cut interest rates in hopes of stimulating economic activity during a recession. Rate cuts typically cause bond yields to fall and bond prices to rise.

For investors in or nearing retirement who want to reduce their exposure to stock market volatility, the period before a recession may be a good time to consider shifting some money from stocks to bonds. That's because the Fed is typically raising interest rates to slow growth, which means lower bond prices and higher yields.

Keep in mind, though, that the bond universe is a far more vast and variegated place than the stock market and not all bonds perform equally well during recessions. Investment-grade corporate bonds and government bonds such as US Treasurys have historically delivered higher returns during recessions than high-yield corporate bonds and Treasurys could outperform corporate bonds in a recession. Moore expects that prices of high-quality corporate bonds will recover strongly once the economy and inflation slow, and the Fed begins cutting rates to stimulate growth.

What about volatility?

Investors who have looked to bonds as safe places to preserve their savings have found their faith tested by the volatility of the past 2 years. Moore points out, though, that during 2021 and 2022, which he calls the worst market conditions in 50 years, bonds still declined much less than did the stocks of the S&P 500 which have experienced a bear market that is not particularly severe by historical standards.

Like stocks, bonds are constantly being bought and sold by investors ranging from governments to your neighbors. That means their prices rise and fall over time. Unlike stocks, however, would-be bond investors who are uncomfortable with the idea that prices rise and fall much like an ocean tide can opt to instead purchase individual bonds rather than shares of bond mutual funds or ETFs.

A popular way to hold individual bonds is by building a portfolio of bonds with various maturities: This is called a bond ladder. Ladders can help create predictable streams of income, reduce exposure to volatile stocks, and manage some potential risks from changing interest rates.

The Federal Reserve is expected to continue raising interest rates until it decides inflation has been brought under control but could stop raising and potentially even lower rates if the economy weakens. A ladder may be useful when yields and interest rates are increasing because it regularly frees up part of your portfolio so you can take advantage of new, higher rates in the future. At the same time, when rates begin to fall, a bond ladder structure can ensure that at least part of your bond portfolio is maintained at the (higher) yields that prevailed when you had originally invested in the ladder. If all your money is invested in bonds that mature on the same date, they might mature before rates rise or after they have begun to fall, limiting your options.

By contrast, bonds in a ladder mature at various times in the future, which enables you to reinvest money at various times and in various ways, depending on where opportunities may exist.

More fun for funds

While it 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. Funds offer a way for investors with fewer assets to get exposure to bonds even if they cannot afford to build a ladder of individual bonds. Moore says he has bought more bonds with longer maturities. “I have bought 10-year Treasury bonds and 10-year bonds from good quality companies because they were yielding 4.25% to 7%. Even if you feel like there's a recession coming, these should be fine.”

Moore believes that market conditions now are similar to 2019 when bond indexes returned almost 10% after a big drop in 2018. “We had a great big drawdown 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 the next 1 or 2 years.”