Bonds performed so poorly last year that investors wonder if they should own them at all. The total bond market as measured by the Bloomberg US Aggregate Bond Index sank 14% in 2022, the worst performance in four decades. But there is a silver lining in all of this carnage, says bond strategist Robert M. Brinker. The coming year is likely to be a strong rebound year. Bonds not only pay lush yields now, but their prices could rise as interest rates peak and perhaps even start to shrink.
Bottom Line Personal asked Brinker how bond investors can position themselves this year, as well as what bond types to avoid and which to favor now…
Bonds imploded in 2022 because the Federal Reserve was forced to raise short-term interest rates at a historic pace to contain spiraling inflation. Higher short-term rates reduce consumer and business spending, cool economic growth and raise unemployment. But higher interest rates also lead investors to demand higher yields on newly issued bonds. When yields rise, the price of existing bonds fall.
Many of these risks will continue into the first half of 2023 because interest rate hikes take time to have an effect. With the strong job market to support household spending and inflation still elevated, the Fed likely will need to keep pushing up short-term rates.
But: By the end of 2023, the overall bond market could recover and produce positive, single-digit returns. That’s because in the second half of 2023, I expect to see a marked shift in the four major factors affecting bonds…
US economy. I anticipate we will be in a recession in the first two quarters of 2023 as unemployment rises to 4% or more, followed by a slow recovery. Some economists think US gross domestic product (GDP) growth will be in the 2%-to-3% range next year. But I am more cautious and think growth will be marginal, up 0.5% at best.
Short-term interest rates. The Federal Reserve is likely to raise rates to between 4.5% and 5%, up from a range of 4.25% to 4.5% in mid-December 2022. But this will be the peak of the rate-hike cycle. If the economy falters badly, we could even see one or more 0.25% interest rate cuts in the second half of the year.
Long-term interest rates. Yields on the 10-year US Treasury bill stood at 3.5% in December 2022. It could fall to 3% by the end of this year, boosting prices on many long-term bonds.
Inflation. I expect inflation as measured by the core Consumer Price Index to slowly moderate to 4% by the end of 2023, down from 6.1% in December 2022, thanks to the slowing economy and decreased consumer spending.
My strategy for 2023: Sit out the risky first half of the year in short-term US Treasuries, which you hold to maturity, including the three-month note (recent annual yield of 4.61%)…the six-month (recently 4.79%)…and if you are more conservative, the 12-month (recently 4.73%). You can buy Treasuries commission-free at
TreasuryDirect.gov.
By the second half of the year, fixed-income opportunities will emerge and some areas of the bond market will rebound. Avoid bonds with low-quality credit ratings because defaults are likely to rise in the economic recession that I’m forecasting. Instead, stick with very high-quality government and corporate bonds, and extend the length of your maturities. Long-term bonds will start looking very attractive as soon as the Fed pauses its interest rate hikes and contemplates cutting them.
Floating-rate securities. These are short-term, adjustable-rate loans that banks make to corporate borrowers. Their yields typically reset every 30 to 90 days, so they keep pace with rising interest rates. They were the best performers of any bond asset class in 2022, down 1.5%, and yields were recently in the 6%-to-7% range. Problem this year: These bondlike securities often have the same low-quality credit rating as junk bonds, which means they have a high risk for default on loan payments in a recession.
High-yield (junk) bonds. These did relatively well in 2022, buffered by yields in the 8% range. But in a shaky economic environment, in which you can easily get a 4% risk-free return on US Treasuries, an 8% yield isn’t enough compensation. If we hit a deep recession, this category of low credit-rated companies could easily see double-digit losses.
The following four funds, which focus on bonds with high credit quality, are likely to perform better than the overall bond market in 2023…
Vanguard Long-Term Treasury Fund (VUSTX). Last year, long-term bonds fell 27% because they are highly sensitive to rising interest rates. In 2023, they are likely to be the biggest winners as interest rates stop rising and may even fall. This Vanguard fund’s 90 holdings have an effective duration—a measure of how sensitive a bond fund is to changes in interest rates—of 16 years. That means if the 10-year US Treasury yield drops 1%, the value of this fund’s portfolio would rise 16%. Recent yield: 4.5%.* 10-year performance: 1.2%. Investor.Vanguard.com/home
Vanguard Long-Term Tax-Exempt Fund (VWLTX). Municipal bonds, which typically are issued by state and local governments, were down 10% last year. Prospects look excellent in 2023 because municipalities with good credit ratings will remain fiscally strong even if there is a recession. This fund is popular with high-income individuals because it provides higher after-tax yields than comparable US Treasury funds. The 3,000-plus high-quality muni bonds it holds pay interest that is exempt from federal taxes (and sometimes state and local taxes). Its recent 3.7% yield would be worth nearly 6% to an investor in the 37% income tax bracket. 10-year performance: 2.7%.
DoubleLine Total Return Fund (DLTNX) specializes in mortgage-backed securities—large groups of high-quality residential home mortgages that are bundled together and then sold as investments. These securities are backed by the federal government against default but tend to offer higher yields than comparable intermediate-term US Treasuries. This fund, which lost 12% in 2022, is run by Jeffrey Gundlach, one of the best managers in fixed-income markets today. The fund’s 2,800 mortgage-backed securities will do well this year because mortgage rates are likely to come down. Recent yield: 3.5%. 10-year-performance: 1.3%.
DoubleLine.com
Vanguard Short-Term Investment Grade Fund (VFSTX). Short-term bonds with maturities ranging from one to three years fell just 5% in 2022 because they have little sensitivity to rising interest rates. This fund keeps 15% of its assets in government bonds and 75% in high-quality corporate bonds from companies with strong balance sheets such as American Express and Walmart to eke out higher yields than owning just US Treasuries. This year, you likely will see total returns of about 5% from this fund…and slightly more if interest rates are cut. Recent yield: 4.67%. 10-year performance: 1.4%.
