Bonds in 2023: Keep calm and clip the coupons

Bonds in 2023: Keep calm and clip the coupons

Time to read: Minutes
Christian Wilson

Christian Wilson, CFA

Head – Global Client Portfolio Management

Higher income has reduced near-term risk and is setting up the bond market for a run of attractive long-term returns.

Highlights

  • Poised to get back on track: Bond returns have typically been strong in the year following a selloff.
  • More reward for less risk: At current yields, the income earned on bonds provides a return buffer even if rates continue to rise.
  • Bonds are well positioned for the long term: Historically, there has been a strong correlation between starting yield and future returns.

2022 bond rout sets the stage for strong returns

Bonds, often thought of as the anchor of a broader portfolio, posted a 13% loss in 2022, the worst calendar year for the Bloomberg US Aggregate Bond Index (the “Agg”) in at least 30 years (Exhibit 1).

Exhibit 1. 2022 bucked the bond market’s longer-term trend of steady performance
Bloomberg US Aggregate Bond Index calendar year returns (%)
Exhibit 1. 2022 bucked the bond market’s longer-term trend of steady performance

As of 12/31/22. Source: Bloomberg. Investors cannot invest directly in an index. Past performance does not guarantee future results.

For some investors, the fallout in fixed income markets has raised questions about the role bonds play in strategic asset allocations. However, we believe this is a time to consider adding to bonds, not stepping away. In fact, the broader bond market has historically delivered strong returns in the year following a selloff. In addition, current market dynamics have significantly enhanced the risk profile of bonds. Here’s why.

Higher income means less risk in the near term

Rising interest rates are generally bad for bonds, especially for those with longer-dated maturities. But not all rate increases have an equal impact on a bond’s total return. If rates are very low to begin with, the impact of rising rates on bond returns will be much larger, because the starting yield provides less of a buffer, and the change in relative terms is much larger, as shown in Exhibit 2. And that is exactly what happened in 2022. The yield for the Agg started 2022 at 1.75%. By the end of 2022, the yield on the Agg had jumped to 4.68% — a staggering increase in percentage terms, with little income to offset the price decline.

Rate increases are like driving a car: zero to 60 mph can knock you back in your seat, but once you’re going fast, speeding up is less noticeable.

Exhibit 2. When rates rise from already high levels, bonds suffer less
Exhibit 2. When rates rise from already high levels, bonds suffer less

Source: Voya Investment Management. For illustrative purposes only.

As rates increase to more normalized levels, the negative impact from additional rate moves higher starts to wane — which is the environment we are in today. The higher yield earned on bonds serves as an extra cushion from price deterioration if rates continue to rise.

As illustrated in Exhibit 3:

  • The Agg could absorb an 88 basis point increase in its yield and investors would still break even — meaning that the income generated would fully offset the decline in price (scenario 1).
  • Even if rates rose to their peak level from the past 20 years, the total return loss would be relatively modest (scenario 2).
  • If rates fall back to their 20-year average, it would translate to a total return of more than 10% (scenario 3).
  • And if the Fed were to unexpectedly cut rates due to a hard economic landing, the total return would be more than 15% (scenario 4).
Exhibit 3. Expected returns for the Agg in different interest rate scenarios 1
Bloomberg US Aggregate Bond Index
Exhibit 3. Expected returns for the Agg in different interest rate scenarios 1

As of 02/15/23. Source: Bloomberg. 1) Calculations based on the Agg’s current duration of 6.3 years and assume immediate parallel shift in yield curve and the new yield is then earned for the 12-month period. Investors cannot invest directly in an index.

The strong correlation between starting yield and future returns

Rates were extraordinarily low for a very long time. Given this environment, many advisors likely forgot the important role that income plays in long-term total returns for bonds. Historically, the starting yield of the Agg has been a good indicator for long-term returns. Exhibit 4 show relationship between starting yield and rolling returns over various time horizons.

Exhibit 4. Starting yield has been a good indicator of long-term future returns
Exhibit 4. Starting yield has been a good indicator of long-term future returns

Rolling periods from 1976 to 2022. Source: Bloomberg. Information shown is for the Bloomberg US Aggregate Bond Index. Investors cannot invest directly in an index

A key reason to own core fixed income is to diversify equity and credit risk. While that assumption didn’t hold up well in 2022, the great news for bond investors is that interest rate normalization has returned us to a world in which income is a meaningful component of return. In addition, if recession risk increases, core bonds could rally due to their safe-haven status. Against this backdrop, we believe there is a wider range of scenarios that can lead to positive returns for bonds. In our view, the asset class should remain a key part of any strategic allocation.

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Past performance does not guarantee future results. This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults, (5) changes in laws and regulations and (6) changes in the policies of governments and/or regulatory authorities. The opinions, views and information expressed in this commentary regarding holdings are subject to change without notice.

The principal risks are generally those attributable to bond investing. All investments in bonds are subject to market risks as well as issuer, credit, prepayment, extension, and other risks. The value of an investment is not guaranteed and will fluctuate. Market risk is the risk that securities may decline in value due to factors affecting the securities markets or particular industries. Bonds have fixed principal and return if held to maturity, but may fluctuate in the interim. Generally, when interest rates rise, bond prices fall. Bonds with longer maturities tend to be more sensitive to changes in interest rates. Issuer risk is the risk that the value of a security may decline for reasons specific to the issuer, such as changes in its financial condition.

The Bloomberg US Aggregate Index is a widely recognized, unmanaged index of publicly issued investment grade US government, mortgage-backed, asset-backed and corporate debt securities. The Index does not reflect fees, brokerage commissions, taxes or other expenses of investing. Investors cannot directly invest in an index.

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