Bond outlook 2023: bullish on bonds

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Gene Tannuzzo, CFA, Global Head of Fixed Income

2023 is set to be a comeback year for fixed income.

The fixed income engine will shift from rate hikes to the economy (and likely recession)

Rising rates and tighter financial conditions have pushed fixed income yields lower in 2022. As we approach 2023, we should see the economy slow down quite dramatically. I don’t think we’ll see a repeat of 2008 or 2020, in which the downturn was extraordinarily deep in specific areas of the economy. Instead, because financial conditions have tightened so much, I think the economic pain will hit the tail end of every industry. This means that businesses and consumers with too much indebtedness and sovereign states that are not well placed to deal with high levels of currency volatility will come under increased pressure.

Credit quality and selection will be important buffers for investors

Investors no longer benefit from policy-based buffers, like quantitative easing or artificially low rates, to protect their portfolios. In the absence of monetary and fiscal stimulus, they will have to find new buffers to cushion the impact of market and economic volatility. From an implementation perspective, this means a higher credit quality portfolio and companies with strong fundamentals, healthy cash flow and lower leverage. It may also involve moving away from certain risks – including securities overexposed to the low end of consumer credit – and owning asset classes like municipal bonds and agency mortgage-backed securities.

Higher returns can mean portfolio protection

Widespread bond repricing and the higher starting yields we currently have may help protect investors from further losses. The yield curve is very flat and very high, which means that even if investors are not comfortable with longer-term bonds, there are attractive opportunities in short-term corporate bonds, which yield 5.5% or 6%.

Don’t try to time the Fed’s pivot to rate hikes

For those comfortable with longer duration bonds, pay attention to the duration narrative. I think this will shift from focusing on the aggressive Fed hike cycle to focusing on the impact of the Fed suspending (if not scaling back) rate hikes. We have seen negative returns in the bond market followed by high, even double-digit returns. However, a market response at the end of the up cycle usually happens very quickly, and trying to time the bottom may mean an investor misses out.

Bond valuations are very attractive, but watch out for risk

With government-backed mortgage-backed securities priced around $80 and long-dated, high-quality bonds in the $70s, the combination of income and price appreciation can drive returns significant totals once the sentiment turns. Similarly, investment grade bonds, down 20% this year, could offer better returns as they represent companies that do not necessarily need to refinance in a less favorable environment. If we look at international bonds, it’s probably the first time in many years that opportunities in Europe look more attractive relative to the US – especially in investment grade bonds, which have already priced in geopolitical risk. High yield seems fully valued to us, but could benefit if the economy manages to avoid a recession in the coming year.

Bonds are positioned for an underperformance reversal

Optimism for 2023

I don’t think 2023 will be a repeat of 2022. There are some very attractive total return opportunities in high quality assets. Investors are rewarded in terms of return, but there are risks, and a focus on credit quality and selection will be key to paving the way for successful fixed income results.

Disclosures

There are risks associated with fixed income investments, including credit risk, interest rate risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is generally more pronounced for longer-term securities.

NOT FDIC INSURED No bank guarantee May lose value

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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.

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