The bond market was one of 2022’s big question marks.
Last year’s stock market took a big hit. Marked by significant volatility, the S&P 500 ended the year down about 20%. But bear markets happen, and stocks are known for their short-term volatility.
On the other side, bonds aren’t known for stomach-churning swings. The bond market is generally known for its stability. That’s arguably its biggest selling feature. Investors can often expect lower returns but more safety when they invest in bonds instead of equities.
That wasn’t the case in 2022, though. Not only were bonds unusually volatile, but bonds and equities declined at the same time. According to research from Goldman Sachs, this has only happened a handful of times in the past 100 years.
All of this raises the question: What will 2023 bring for bonds? Should financial professionals approach with optimism or caution? SmartAsset spoke with Mariam Kamshad, head of portfolio strategy for Goldman Sachs personal financial management, and Guido Petrelli, CEO and founder of Merlin Investor, to discuss.
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Expect a Return to Stability
“Most bond investors will be glad to turn the page on 2022,” Kamshad says.
Fortunately, it looks like they’ll get that chance.
One of the important things to remember is that 2022 was an unusually bad environment for bonds, Kamshad says. Coming out of the COVID-19 pandemic, the year started with rock-bottom interest rates leading to historically low yields.
Over the course of the year that swung to the opposite extreme, with the Federal Reserve pumping rates to a 15-year high point. The combination led to not only significant volatility but “deep losses” for fixed-income portfolios, Kamshad says.
That’s unlikely to repeat. Interest rates entering 2023 are high relative to post-Recession years, but not historically so. (Indeed, rates are still relatively low compared with much of the 20th century.) And a strong, but cooling, economy is likely to lead to a less aggressive Federal Reserve, but not necessarily a reversion to the era of 0% interest. The upshot is Kamshad expects both yields and capital gains returns to stabilize.
Pay Attention to Inflation and Government Bonds
With Federal Reserve interest rates driving the bus, it’s easy for investors to get tunnel vision on that one data point. But that may be a mistake.
Looking ahead, Kamshad recommends that investors and financial professionals pay attention to at least two other important issues when it comes to bond investing.
First, remember that inflation is still arguably the biggest issue in the economy right now. The eroding value of cash relative to long-term investments has been critical for fixed-income investors.
Kamshad and her team believe that inflation will continue slowing in 2023. This will likely slow interest rates, especially if a recession creates other priorities for the Federal Reserve. It also changes the risk analysis for long-term investors, creating an environment in which Kamshad and her team consider duration risk a better bet than credit risk.
Second, and relatedly, bond investors may consider investing in government bonds again. Thanks to slowing inflation and rising interest rates, Kamshad’s team expects intermediate Treasurys to outperform cash again. They also expect municipal bonds to pick back up as, despite poor performance last year, the fundamentals of sales and property taxes remain strong.
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A potential recession is one of the biggest questions facing the bond market right now, Petrelli says. He expects that economic performance as a whole will affect the bond market in two ways.
The first impact will be the balance between equity and fixed-income investing.
“I believe the key point is to see if the aggressive approach of the U.S. Federal Reserve will push the economy into a recession,” he says. If there is a significant recession, then Petrelli expects a move back toward bonds. Stabilized inflation and interest rates will make this an attractive safe-harbor market once again.
On the other hand, the stock market has entered 2023 “significantly beat up.” This creates an opportunity for equity investors to potentially buy into discounted assets. If the economy remains strong, or if a recession is relatively short-lived, Petrelli expects a bigger move out of bonds and into stocks, cutting into returns but potentially creating an opportunity for bond purchases.
Second, in the face of a recession, Petrelli expects investors to favor short-term bonds. A recession would create significant uncertainty around the Federal Reserve’s next steps. This, combined with uncertainty in the stock market and the high rates for newly issued debt, would incentivize short-term assets as a form of wait-and-see. In a stronger economy, these incentives won’t be as significant, and the market is unlikely to heavily favor short-term instruments.
In both cases, investors would be wise to follow the U-3 unemployment rate (the official, or headline, rate), the U-6 unemployment rate (otherwise known as the underutilization rate) and the quit rate. Together, these are good metrics for the strength of the economy overall and a window into where bonds are headed.
Bottom Line
The bond market in 2022 was one of the most volatile in memory, paired with the rare event of declining bonds and stocks at the same time. In the coming year, investment professionals should expect a more stable bond market, but one in which performance will be dominated by questions of inflation and recession.
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