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We believe that the rough year for bonds in 2022 may have set the stage for strong performance in fixed income markets going forward.
In our view, central banks have largely been successful in containing inflation and we anticipate a decline in inflation in 2023.
In our view, aggressive central bank action has created a potential buying opportunity in high quality fixed income in 2023.
The bond market had a historically negative year in 2022. The US investment grade fixed income market returned -13.01% and returns on European and Asian fixed income markets were also very negative.1 There was nowhere to hide. Given this very negative performance, what is our outlook for 2023?
The bottom line is that we are positive on the outlook for fixed income in 2023 and believe that what happened in 2022 may have set the stage for strong performance in fixed income markets going forward and renewed investor interest in public fixed income.
2022 reset bond yields higher and moved the market broadly out of the low/negative yield environment that has prevailed since the Global Financial Crisis. In fact, real yields (the yield that bonds provide after considering inflation) have moved from negative levels to positive levels that have not been seen since 2013.2
Unprecedented central bank easing and government spending during the depths of the pandemic led to a strong bounce in growth once COVID measures eased and economies re-opened. This strong growth recovery along with temporary supply chain problems drove inflation sharply higher in the US and Europe.
Fortunately, central banks moved aggressively to counter this rise in inflation and to ensure that it would not become entrenched in the global economic landscape. This aggressive response bolstered their credibility. In our view, central banks have largely been successful in containing inflation and we now believe the peak in inflation is behind us. We anticipate a decline in inflation in 2023.
A simple way to think about this is that after more than a decade of keeping rates abnormally low (and real yields negative), the stimulus-related bump in inflation in 2023 caused central banks to move aggressively to rerate yields higher. This caused negative returns for existing holders of bonds, but we believe it also set the stage for strong performance from bonds going forward.
Source: Macrobond. Data from Jan. 1, 2016, to Dec. 1, 2022. CPI stands for Consumer Price Index.
In our view, aggressive central bank action has created a potential buying opportunity in high quality fixed income in 2023. Government bond yields and real yields have risen sharply. In addition, credit spreads in many high quality fixed income asset classes have widened and are attractive, in our view. All-in yields in a number of high quality fixed income credit asset classes look as attractive as they have since the Global Financial Crisis of 2008. The period of suppressed yields that had prevailed since the Global Financial Crisis is over, and we believe bonds now offer a compelling income opportunity for investors.
Source: Macrobond. Data from June 2, 2000, to Jan. 13, 2023. Based on the Bloomberg US Aggregate Bond Index and the Bloomberg Euro-Aggregate Index.
In short, we believe the bond market holds the greatest potential that we’ve seen since the Global Financial Crisis, and there are compelling reasons for investors to take a closer look at this opportunity now.
Source: Macrobond. Data from Dec. 27, 2022, to Jan. 2, 2023
6. Investors hold a lot of cash and floating rate assets in aggregate. When central banks are aggressively raising interest rates, it makes sense to hold cash or floating rate assets whose interest rates will adjust in line with central bank rate increases. Investors appear to have done this, putting money into money market funds and floating rate assets. When central banks are close to the end of their rate hike cycle, however, it may make sense for certain investors to rotate back into fixed rate assets, such as high quality bonds. Redeploying this cash into bonds may be very supportive of bond market performance in 2023.
Source: Macrobond. Data from Jan. 4, 2016, to Jan. 9, 2023
Investment grade corporate bonds currently offer yields rarely seen since the Global Financial Crisis. Investment grade bonds are high quality bonds issued by some of the largest global companies. Even in recessions and other periods of economic stress, defaults in investment grade corporate bonds are likely to be rare. The current yields on offer in these high quality assets represent strong income potential for investors with a high probability of capital return. Investment grade corporate bonds have tended to generate very strong returns in the year after central banks finish a rate hike cycle.3
Municipal bond yields have reset higher in line with the overall market, despite a very strong fundamental backdrop for municipal issuers. Large outflows from retail investors who sold municipal bonds as prices declined may have set the stage for a strong rebound in municipals in the coming year, in our view. Municipal bonds come in two types, tax-exempt and taxable, which provide options for both retail and institutional investors.
Valuations across several investment grade non-agency residential mortgage-backed security (MBS) sectors stand out as attractive currently: single-family rental bonds, non-qualified MBS senior bonds and Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac) senior credit risk transfer securities are all attractive on an absolute yield and relative yield basis, in our view, compared to investment grade corporates. Yields on AA and A-rated non-agency bonds can be found in the 6.0%-6.25% range.4 While selling related to mutual fund outflows negatively impacted this sector, among others, we expect the supply picture to continue to be very supportive to spreads, given high mortgage rates and lower production.
As US yields have rerated higher and as the Fed has tightened financial conditions, the US dollar has strengthened and now looks somewhat overvalued against most other currencies, in our view. When central banks stop hiking and the current patch of somewhat below-trend growth passes, we would expect the US dollar to give back some of its recent gains, which may provide a tailwind for global debt, both developed and emerging market, measured in US dollars.
High yield corporate bonds offer much-improved yields and have benefited from the overall rise in real yields. The potential issue with high yield corporate bonds is that they are lower credit quality than the investment grade sector and are potentially more sensitive to a recession. Credit deterioration during a period of slow growth may be a headwind for high yield. We are looking for more clarity on the economic path through 2023 and the resilience of the global economy to fully analyze the high yield opportunity.
Source: Bloomberg, L.P. US investment grade represented by the Bloomberg US Aggregate Bond Index, an unmanaged index considered representative of the US investment-grade, fixed-rate bond market. European fixed income is represented by the Bloomberg Euro-Aggregate Index measured in euros, and Asian Fixed income is represented by the Bloomberg Asian-Pacific Aggregate Index measured in US dollars.
Source: Bloomberg L.P. US real yields are derived from the yield of US Treasury Inflation Protected securities. The yield of the Treasury Inflation Protected 3.375% 4/14/32 was -1.09% as of 12/31/2021, and was 1.79% as of 12/30/2022.
Source: Macrobond, as of Nov. 28, 2022. Based on Bloomberg US Corporate Index annualized return data for one year after the end of Federal Reserve rate hiking cycles in August 1984 (27.41%), February 1989 (11.97%), February 1995 (14.32%), May 2000 (14.29%), July 2006 (5.41%) and December 2018 (14.54%).
Source: Invesco, as of Jan. 17, 2023.
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This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.
All investing involves risk, including the risk of loss.
Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates.
Junk bonds involve a greater risk of default or price changes due to changes in the issuer’s credit quality. The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods.
The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
There is a risk that the value of the collateral required on investments in senior secured floating rate loans and debt securities may not be sufficient to cover the amount owed, may be found invalid, may be used to pay other outstanding obligations of the borrower or may be difficult to liquidate.
Municipal securities are subject to the risk that legislative or economic conditions could affect an issuer’s ability to make payments of principal and/ or interest.
Mortgage- and asset-backed securities are subject to prepayment or call risk, which is the risk that the borrower’s payments may be received earlier or later than expected due to changes in prepayment rates on underlying loans. Securities may be prepaid at a price less than the original purchase value.
Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.
The Consumer Price Index (CPI) measures change in consumer prices as determined by the US Bureau of Labor Statistics for the US, and Eurostat for the Euro Area. Core CPI excludes food and energy prices while headline CPI includes them.
The Bloomberg US Aggregate Bond Index, an unmanaged index considered representative of the US investment-grade, fixed-rate bond market.
The Bloomberg Euro-Aggregate Corporate Bond Index is a rules based benchmark measuring investment grade, EUR denominated, fixed rate, and corporate only. Only bonds with a maturity of one year and above are eligible.
The Bloomberg Asian-Pacific Aggregate Index contains fixed-rate, investment-grade securities denominated in Japanese yen, Australian dollar, Hong Kong dollar, Malaysian ringgit, New Zealand dollar, Singapore dollar, South Korean won and Thai baht. Inclusion is based on currency of the issue and not the country of risk of the issuer. The index is composed primarily of local currency sovereign debt, but also includes government-related, corporate and securitized bonds.
Credit spread is the difference in yield between bonds of similar maturity but with different credit quality.
Treasury Inflation-Protected Securities (TIPS) are US Treasury securities that are indexed to inflation.
The opinions referenced above are those of the author as of Jan. 24, 2023. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.
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