by Blaine Dickason
Senior Vice President Trading and Fixed Income Portfolio Management
Bonds made headlines last year for all the wrong reasons. Spurred by dramatic interest rate increases from the Federal Reserve, the U.S. bond market posted its worst annual performance in modern history. As a result of last year’s sell-off in bonds, bond yields have reset to higher levels not seen in over a decade. While we welcome the return of this attractive income, the current level of interest rates has also positioned bonds to once again provide their traditional role of ‘insurance’ during uncertain times. Accordingly, we have recently begun adding to our bond allocation to take advantage of these market conditions.
The benchmark measure of domestic investment grade bonds is the Bloomberg U.S. Aggregate Index. At the start of 2022, this bond index yielded less than 1.8%. In comparison, the average yield of this index has been just 2.4% over the last 10 years. By the end of 2022 and driven by the bond price declines of last year, its yield rose to 4.7%. Whereas in the prior decade, bonds appeared relatively unattractive compared to other asset classes, at current prices and yields, bonds now offer a more competitive alternative within balanced account asset allocations.
There is undeniable concern that the slowdown in economic momentum being engineered by the Fed will lead the U.S. into a recession. While the likelihood of either a hard or soft landing this year will continue to be debated, we can look back to prior U.S. recessions for a refresher on the role bonds played in diversified accounts. Noted in blue in the chart below is the income component of bonds’ total return, which was known at the start of each year. The added change in value, seen in green, was the ‘insurance’ or price appreciation that boosted total return, as the realization of recession later that year led interest rates lower.
Source: Bloomberg
The Federal Reserve has already slowed their pace of interest rate hikes as they approach their assessment of peak rates. As you’ve undoubtedly heard with regards to stocks, interest rate markets are also discounting mechanisms, and have already begun forecasting lower yields beyond the current year as both inflation and growth expectations have been trending lower when compared to last year. Just as last year’s higher rates drove significant price declines, the anticipation of lower future yields has led to an increase in bond prices to start the year. In fact, the Bloomberg U.S. Aggregate Index performance is having its best start to a year since 1991, yet as of this writing still offers a yield in excess of 4%. After the hard reset to bond markets in 2022, we believe bonds are once again positioned to deliver on their traditional twin pillars of real income and insurance for client portfolios.
Takeaways for the Week:
So far in January, 11% of the S&P 500 has reported their Q4 2022 earnings, with 64% of reporting companies beating earnings estimates.
Current estimates for the calendar year 2023 S&P 500 earnings now stand at +3.5% growth year-over-year.