A glass half full: bonds now offer better values than they have in years
There’s no arguing that 2022 wasn’t a brutal year for the bond markets. Virtually every segment suffered material declines, with investors’ risk aversion sending spread sectors lower while rising interest rates pushed rate-sensitive securities into the red.
In the end, the Bloomberg U.S. Aggregate Bond Index lost just over 13%, only its sixth calendar-year loss in the index’s history and the worst year for bonds since the Great Depression.1 With the damage done, though, two important questions remain for investors: What exactly caused such an outlier of a collapse and, even more vitally, how should investors respond?
The pace of rate increases has been unusually aggressive
It would be an understatement to say that the two parts of the U.S. Federal Reserve’s (Fed’s) dual mandate—full employment and price stability—don’t always require equal attention. The postpandemic labor market in the United States has been, and remains, exceptionally strong, with unemployment recently touching a 53-year low. Inflation, of course, has been another story.
When the Fed began its current tightening cycle in March 2022, inflation was already growing by more than 8% year over year and had risen in 10 of the past 12 months since it first crossed the 2% threshold in March 2021. There’s a saying about hindsight, but it’s clear that the Fed was late to start raising rates and likely still has some catching up to do. The trajectory of the hikes bears this out; not even in 1994 has the pace of interest-rate increases been this severe.
The Fed's current tightening cycle has sent rates higher, faster
Of course, the swiftness and severity of the tightening contributed directly to the pain investors felt in 2022. There simply wasn’t enough time for whatever income bonds generated to offset the price declines they suffered—nor was there enough income. Yields were so exceptionally low when the Fed began to tighten—the 10-year U.S. Treasury was offering little more than 2%—that losses were all but inevitable.
So what next? While we’re not in the business of making predictions about rates, we’d imagine that, with 475 basis points of rate increases already on the books, the Fed is either currently at or near the end of its tightening cycle. While March’s inflation data came in at 5%, it has fallen in every month since June 2022—and there are other factors at work that may help dampen inflation. It wouldn’t surprise us if the current turmoil in certain segments of the banking sector led to more stringent lending standards, which itself could have a tightening effect on the supply of money. Even if the Fed still has one or two rate hikes left to make, at this point in the cycle, we don’t think avoiding duration risk outright is likely to offer much benefit.
Short duration bonds are unlikely to repeat last year’s performance
Although the category still recorded losses in 2022, short duration bonds were among the best-performing fixed-income segments last year. Given the one-two punch of investors dialing down risk and interest rates rising across the board, that’s not surprising. But we feel short duration’s relative outperformance is unlikely to last. Looking back at the past four tightening cycles, the Fed has paused for anywhere from 7 to as many as 15 months between its final hike and its next rate cut. While it’s always possible that this time will indeed be different, the point is that it’s been exceedingly rare to see the Fed pivot on a dime and immediately shift from a tightening to an easing policy.
During those plateaus between policy shifts when rates are relatively stable, history shows that intermediate-term bonds significantly outperform their short duration counterparts. And when rates begin to fall, of course, that pattern of outperformance has generally continued: duration helps.
Intermediate-term bonds have historically outperformed when policy rates are relatively stable
|U.S. Federal Reserve rate hike cycle||10-year UST yield as of final rate hike
||10-year UST yield as of first subsequent rate cut||Number of days between final hike and first cut||Change in 10-year UST yield (bps)||Cumulative return, Bloomberg U.S. Aggregate Bond Index||Cumulative return, Bloomberg 1–3 Year U.S. Aggregate Bond Index|
Source: Morningstar Direct, as of March 31, 2023. It is not possible to invest directly in an index. One hundred basis points (bps) equals one percent. See endnotes for index definitions. Past performance does not guarantee future results.
If history is any guide, it suggests that whatever risk-dampening benefits short duration bonds have to offer are relatively short lived.
There’s another, somewhat less appreciated risk factor looming for investors in the short duration space: reinvestment risk. If the U.S. economy does hit a recession and the Fed is forced to begin cutting rates, short duration investors will need to constantly reinvest the proceeds of maturing securities at lower and lower yields—which is hardly an attractive proposition. It’s also worth emphasizing just how quickly the markets have been moving this year, especially on the shorter end of the curve. The 2-year U.S. Treasury traded at 5.05% on March 8; by the day after the Fed’s most recent meeting (March 23), it had fallen to 3.76%. That’s a sizable swing in just over two weeks. An earlier-than-expected rate cut from the Fed would likely create additional headaches for investors that needed to reinvest the principal of maturing short-dated securities. The bottom line is that less duration in this environment doesn’t necessarily mean less risk.
Starting yields have always been a significant driver of total returns
While we’re unapologetic believers in the value of active management, there are certain maxims that are true of the market in general. One of them is that, all else being equal, higher starting yields are correlated with higher forward total returns. That’s good news for investors with any unallocated capital to deploy: Yields today in the high-yield space are on par with the distressed levels they hit in 2020, while the investment-grade segment is offering yields not seen since 2008. We believe these levels represent extremely attractive entry points given the health of the underlying economy. While it’s entirely possible the economy slides into a recession in the next 12 months, slowing growth has historically only served as a further tailwind to high-quality bonds as investors rotate out of riskier assets.
While in the end, 2022 was undeniably a historically tough year for bonds, one can’t move forward while looking in the rear-view mirror—and that’s certainly true of investing. That said, we believe it’s unlikely that 2023 brings just more of the same. With substantially higher yields and a reasonably solid economic backdrop, intermediate-term bonds in the core and core-plus spaces look more attractive now than they have in years—especially relative to the low duration or higher-risk options in the market.
1 Bloomberg, as of March 31, 2023.
A note on yields and total returns: Comparing forward total returns vs. starting yield for the Bloomberg U.S. Aggregate Bond Index using regression analysis over rolling 60-month periods since 1976 reveals that roughly 89% of those total returns are attributable to the starting yield: The higher the yield at the time of investment, the higher the five-year total return has tended to be.
Index definitions: The Bloomberg 1–3 Year U.S. Aggregate Bond Index tracks publicly issued medium and larger issues of U.S. government, investment-grade corporate, and investment-grade international U.S. dollar-denominated bonds that have maturities of between one and three years. The Bloomberg U.S. Aggregate Bond Index tracks the performance of U.S. investment-grade bonds in government, asset-backed, and corporate debt markets. It is not possible to invest directly in an index.
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