The year ahead for bonds

Despite a brief rally in December, the bond market suffered its worst decline in decades as the Federal Reserve rapidly and aggressively raised interest rates in 2022. Bond prices and interest rates move in opposite directions: When interest rates rise, bond prices fall.

All in all, there is “nowhere to hide,” said John Lovito, co-chief investment officer of global fixed income at American Century Investments. The broad bond benchmark, the Bloomberg U.S. Aggregate Bond Index, fell 11.6% in the 12 months through early December.

To make matters worse, stocks also fell. Part of the reason people buy bonds is to cushion a stock market fall, but bonds have not fared much better than stocks over the past year. “It’s making people slur their tongues,” said Lew Altfest, a financial advisor at Altfest Personal Wealth Management.

However, things often look the worst before they get better, and today, most analysts agree that the bond market is at an inflection point. “Bonds will come back in 2023,” said Luis Alvarado, an investment strategy analyst with the Global Fixed Income Strategies Team at Wells Fargo Investment Institute.

The worst of the rate hike may be behind us. Most analysts expect the Fed to raise short-term interest rates several times, by smaller increments (0.50 percentage point or less) than in the past few months, before pausing to assess the impact of rate hikes on inflation. From then on, the Fed could pause for longer, or it could raise rates further if inflation doesn’t cool enough, or it could lower rates if the economy slips into a deep recession.

Regardless, with interest rates higher now, investors should lock in yield as much as possible. For example, the 10-year Treasury note recently yielded 3.55%, up from 1.75% a year ago. That means investors now have a cushion of interest income to offset any decline in bond prices should rates rise, Altfest said.

In addition, investors can earn substantial returns without taking too much risk. “They don’t have to buy long-term bonds or degrade credit quality,” said Mary Ellen Stanek, co-chief investment officer at Baird Asset Management. In fact, a recurring theme for 2023, including from iShares investment strategist Gargi Chaudhuri, is “improving quality.”