2022 was a remarkable year for financial markets. The fact that stocks experienced a bear market wasn’t all that unusual, even coming on the heels of the quick plunge just two years earlier at the beginning of the COVID-19 pandemic in February 2020. What made the year extraordinary is that the bond market performed almost as badly as stocks did.
Bonds in 2022
The Fed raised its benchmark interest rate seven times last year, hoisting it to 4.25% to 4.5% in what were its most aggressive policy moves since the early 1980s. This was hugely consequential for bonds. Bond prices move opposite interest rates — as interest rates rise, bond prices fall. That’s because the value of a bond you hold now will fall as new bonds are issued at higher interest rates. Those new bonds deliver bigger interest payments courtesy of their higher yield, making existing bonds less valuable — thereby reducing the price your current bond can command and dampening investment returns. Many bond fund managers who had bought pricey bonds ultimately sold low when inflation began to surface. Broad-based bond ETFs like the iShares Core U.S. Aggregate Bond and Vanguard Total Bond Market both posted declines of 13% in 2022, even after taking their interest payments into account.
The longer the maturity of the bonds that investors chose, the greater the declines typically were. Think of the maturity date as a bond’s term or holding period. Bond funds holding longer-dated notes generally have a longer “duration.” Duration is a measure of a bond’s sensitivity to interest rates and is impacted by maturity, among other factors. A simple formula to demonstrate as an example: take an intermediate-term bond fund which has a duration of five years. In this case, we’d expect bond prices to fall by 5 percentage points for every 1-point increase in interest rates. The anticipated decline would be 10 points for a fund with a 10-year duration, 15 points for a fund with a 15-year duration, and so on. Thus, long-dated bonds suffered especially big losses in 2022, given interest rates jumped by about 4 percentage points.
Short-term bond investors managed to limit their losses, with the iShares 1-3 Year Treasury Bond ETF posting declines of just 4% in 2022. The longest U.S. government bonds have a maturity of 30 years; such long-dated U.S. notes lost 39.2% in 2022, as measured by an index tracking long-term zero-coupon bonds.
Yields Up, Prices Down
Not only are yields up, prices of many high-quality bonds are down as a result of the 2022 selloff. That means opportunities exist for those with cash to buy relatively low-risk assets at bargain prices even as they pay yields that are higher than they have been in decades. If inflation comes down closer to the 2.5% range where the Fed wants and expects it in 2023, real rates, which are bond yields minus the rate of inflation, could rise further into positive territory. Higher yields enable bonds to once again play their historical role as sources of reliable, low-risk income for investors who buy and hold them to maturity.
Higher rates are good for 2023 bond returns for two reasons. One, even if rates stay where they are, bond investors get a positive return from the interest their bonds generate. That’s a big departure from how bonds have been throughout much of the past decade, with rock-bottom rates offering little or no current income. Moreover, there is potential for interest rates to go back down in 2023. Recessionary conditions often cause a drop in rates, and if that comes, positive gains can be made from rising bond prices to those interest payments to generate an even higher total return.
Even if their prices don’t rise much in 2023, bonds will still pay interest at rates that are set when they are issued and they will also still have a face value (called “par”) that the bondholder will receive when the bond matures, provided that the bond cannot be called by its issuer. This is meaningful for investors who are in or near retirement and want predictable income more than potential capital appreciation. For many years The Fed had been financially repressing savers, especially retirees. Now, higher rates mean that retirees and savers may be able to earn attractive returns without taking much risk in 2023 and beyond.
Window of Opportunity
One reason why 2023 could be better for the bond market than last year stems from pure mathematics. At the beginning of 2022, yields on three-month Treasury bills were at 0.06%, and two-year Treasuries yielded 0.75%. Even long-term rates were low, with 10-year Treasuries at 1.65% and 30-year bonds right around 2%. Fast-forward to today, and short-term Treasuries are yielding 4.35% to 4.75%. Longer-term bonds have yields of roughly 3.7% to 3.8%.
We believe that market conditions as 2023 starts are similar to 2019 and 2020 when bond indexes returned almost 10% after a big drop in 2018. Short term bonds are at especially attractive levels as yields have been climbing over the past twelve months and are near 15 year highs. With less interest rate and credit sensitivity, short-maturity bonds can potentially outperform longer-dated bonds when rates are rising and more credit-sensitive bonds when economic growth is waning.
Historically, starting yields have had a powerful correlation with bond returns, and today’s yields may offer investors both improved opportunities for income generation as well as greater downside cushion. The sharp rise in shorter-dated bond yields means investors can find attractive coupons without taking on the greater interest rate risk inherent in longer-duration bonds. Historically, government bonds are relatively less volatile, and they are generally granted the higher credit quality rating, which can be a tool to help manage volatility within an overall portfolio to cope with slowing economic growth economy.
We see a window of opportunity now provided by today’s higher rates. Getting inflation under control is the focus of Fed policy in the months ahead, but the central bank also wants to make sure it has room to cut rates if the economy goes into recession, potentially in 2023. This means that the opportunity to add low-risk, high-yielding bonds to your income strategy may not be there if you wait too long.
Summary
Low bond yields over the past fifteen years led many investors to raise their stock allocations to achieve their target portfolio returns — perhaps to an overall stock-bond allocation of 70/30 versus 60/40. Going forward, it can make sense for investors who don’t want too much exposure to stocks to reduce their stock allocation given higher bond yields, as investors could achieve the same target returns but with reduced investment risk.
For the first time in decades, bond yields are high enough that income seeking retirees could use them to help support a 4% withdrawal rate from their portfolios. This would mean high-quality bonds may once again be a meaningful contributor for retirees looking to supplement Social Security, pensions, and other sources of income. Whether you want to build a portfolio with Treasury, municipal, investment-grade corporate, or high-yield bonds, you should be able to achieve respectable yield and even achieve strong returns.
For investors on the sidelines with cash, the easiest and most valuable way to take advantage of higher bond yields now is to make sure none of your cash is sitting idle. Americans still have trillions of dollars in bank accounts paying little to no interest. For every $10,000 you have in a non-interest savings account, you’re missing out on $400 to $500 of potential income in 2023, just by investing in ultra-safe short-term Treasury bills.
Overall, investing in bonds is far more attractive this year than it has been in many years. Investors should reassess their portfolios and discuss their fixed income strategy with their investment advisors.
Still have questions about your investment portfolio or retirement strategy? We’ve helped many investors plan for their future. Contact Paraiba Wealth Management at contact@paraibawealth.com or call (415) 742-8223 for a complimentary consultation.
Investment advisory and financial planning services are offered through Paraiba Wealth Management LLC, a Registered Investment Adviser. Intended for educational purposes only. Opinions expressed are not intended as individualized investment advice or a guarantee that you will achieve a desired result. Past performance does not guarantee future results. Consult your financial professional before making any investment decision.
2022 was a remarkable year for financial markets. The fact that stocks experienced a bear market wasn’t all that unusual, even coming on the heels of the quick plunge just two years earlier at the beginning of the COVID-19 pandemic in February 2020. What made the year extraordinary is that the bond market performed almost as badly as stocks did.
Bonds in 2022
The Fed raised its benchmark interest rate seven times last year, hoisting it to 4.25% to 4.5% in what were its most aggressive policy moves since the early 1980s. This was hugely consequential for bonds. Bond prices move opposite interest rates — as interest rates rise, bond prices fall. That’s because the value of a bond you hold now will fall as new bonds are issued at higher interest rates. Those new bonds deliver bigger interest payments courtesy of their higher yield, making existing bonds less valuable — thereby reducing the price your current bond can command and dampening investment returns. Many bond fund managers who had bought pricey bonds ultimately sold low when inflation began to surface. Broad-based bond ETFs like the iShares Core U.S. Aggregate Bond and Vanguard Total Bond Market both posted declines of 13% in 2022, even after taking their interest payments into account.
The longer the maturity of the bonds that investors chose, the greater the declines typically were. Think of the maturity date as a bond’s term or holding period. Bond funds holding longer-dated notes generally have a longer “duration.” Duration is a measure of a bond’s sensitivity to interest rates and is impacted by maturity, among other factors. A simple formula to demonstrate as an example: take an intermediate-term bond fund which has a duration of five years. In this case, we’d expect bond prices to fall by 5 percentage points for every 1-point increase in interest rates. The anticipated decline would be 10 points for a fund with a 10-year duration, 15 points for a fund with a 15-year duration, and so on. Thus, long-dated bonds suffered especially big losses in 2022, given interest rates jumped by about 4 percentage points.
Short-term bond investors managed to limit their losses, with the iShares 1-3 Year Treasury Bond ETF posting declines of just 4% in 2022. The longest U.S. government bonds have a maturity of 30 years; such long-dated U.S. notes lost 39.2% in 2022, as measured by an index tracking long-term zero-coupon bonds.
Yields Up, Prices Down
Not only are yields up, prices of many high-quality bonds are down as a result of the 2022 selloff. That means opportunities exist for those with cash to buy relatively low-risk assets at bargain prices even as they pay yields that are higher than they have been in decades. If inflation comes down closer to the 2.5% range where the Fed wants and expects it in 2023, real rates, which are bond yields minus the rate of inflation, could rise further into positive territory. Higher yields enable bonds to once again play their historical role as sources of reliable, low-risk income for investors who buy and hold them to maturity.
Higher rates are good for 2023 bond returns for two reasons. One, even if rates stay where they are, bond investors get a positive return from the interest their bonds generate. That’s a big departure from how bonds have been throughout much of the past decade, with rock-bottom rates offering little or no current income. Moreover, there is potential for interest rates to go back down in 2023. Recessionary conditions often cause a drop in rates, and if that comes, positive gains can be made from rising bond prices to those interest payments to generate an even higher total return.
Even if their prices don’t rise much in 2023, bonds will still pay interest at rates that are set when they are issued and they will also still have a face value (called “par”) that the bondholder will receive when the bond matures, provided that the bond cannot be called by its issuer. This is meaningful for investors who are in or near retirement and want predictable income more than potential capital appreciation. For many years The Fed had been financially repressing savers, especially retirees. Now, higher rates mean that retirees and savers may be able to earn attractive returns without taking much risk in 2023 and beyond.
Window of Opportunity
One reason why 2023 could be better for the bond market than last year stems from pure mathematics. At the beginning of 2022, yields on three-month Treasury bills were at 0.06%, and two-year Treasuries yielded 0.75%. Even long-term rates were low, with 10-year Treasuries at 1.65% and 30-year bonds right around 2%. Fast-forward to today, and short-term Treasuries are yielding 4.35% to 4.75%. Longer-term bonds have yields of roughly 3.7% to 3.8%.
We believe that market conditions as 2023 starts are similar to 2019 and 2020 when bond indexes returned almost 10% after a big drop in 2018. Short term bonds are at especially attractive levels as yields have been climbing over the past twelve months and are near 15 year highs. With less interest rate and credit sensitivity, short-maturity bonds can potentially outperform longer-dated bonds when rates are rising and more credit-sensitive bonds when economic growth is waning.
Historically, starting yields have had a powerful correlation with bond returns, and today’s yields may offer investors both improved opportunities for income generation as well as greater downside cushion. The sharp rise in shorter-dated bond yields means investors can find attractive coupons without taking on the greater interest rate risk inherent in longer-duration bonds. Historically, government bonds are relatively less volatile, and they are generally granted the higher credit quality rating, which can be a tool to help manage volatility within an overall portfolio to cope with slowing economic growth economy.
We see a window of opportunity now provided by today’s higher rates. Getting inflation under control is the focus of Fed policy in the months ahead, but the central bank also wants to make sure it has room to cut rates if the economy goes into recession, potentially in 2023. This means that the opportunity to add low-risk, high-yielding bonds to your income strategy may not be there if you wait too long.
Summary
Low bond yields over the past fifteen years led many investors to raise their stock allocations to achieve their target portfolio returns — perhaps to an overall stock-bond allocation of 70/30 versus 60/40. Going forward, it can make sense for investors who don’t want too much exposure to stocks to reduce their stock allocation given higher bond yields, as investors could achieve the same target returns but with reduced investment risk.
For the first time in decades, bond yields are high enough that income seeking retirees could use them to help support a 4% withdrawal rate from their portfolios. This would mean high-quality bonds may once again be a meaningful contributor for retirees looking to supplement Social Security, pensions, and other sources of income. Whether you want to build a portfolio with Treasury, municipal, investment-grade corporate, or high-yield bonds, you should be able to achieve respectable yield and even achieve strong returns.
For investors on the sidelines with cash, the easiest and most valuable way to take advantage of higher bond yields now is to make sure none of your cash is sitting idle. Americans still have trillions of dollars in bank accounts paying little to no interest. For every $10,000 you have in a non-interest savings account, you’re missing out on $400 to $500 of potential income in 2023, just by investing in ultra-safe short-term Treasury bills.
Overall, investing in bonds is far more attractive this year than it has been in many years. Investors should reassess their portfolios and discuss their fixed income strategy with their investment advisors.
Still have questions about your investment portfolio or retirement strategy? We’ve helped many investors plan for their future. Contact Paraiba Wealth Management at contact@paraibawealth.com or call (415) 742-8223 for a complimentary consultation.
Investment advisory and financial planning services are offered through Paraiba Wealth Management LLC, a Registered Investment Adviser. Intended for educational purposes only. Opinions expressed are not intended as individualized investment advice or a guarantee that you will achieve a desired result. Past performance does not guarantee future results. Consult your financial professional before making any investment decision.
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