2023 outlook: The opportunity in bonds

The bond market had a historically negative year in 2022. The US investment grade fixed income market returned -13.01% and returns on European and Asian fixed income markets were also very negative.¹ There was nowhere to hide. Given this very negative performance, what is our outlook for 2023?

The bottom line is that we are positive on the outlook for fixed income in 2023 and believe that what happened in 2022 may have set the stage for strong performance in fixed income markets going forward and renewed investor interest in public fixed income.

What happened in 2022?

2022 reset bond yields higher and moved the market broadly out of the low/negative yield environment that has prevailed since the Global Financial Crisis. In fact, real yields (the yield that bonds provide after considering inflation) have moved from negative levels to positive levels that have not been seen since 2013.²

Unprecedented central bank easing and government spending during the depths of the pandemic led to a strong bounce in growth once COVID measures eased and economies re-opened. This strong growth recovery along with temporary supply chain problems drove inflation sharply higher in the US and Europe.

Fortunately, central banks moved aggressively to counter this rise in inflation and to ensure that it would not become entrenched in the global economic landscape. This aggressive response bolstered their credibility. In our view, central banks have largely been successful in containing inflation and we now believe the peak in inflation is behind us. We anticipate a decline in inflation in 2023.

A simple way to think about this is that after more than a decade of keeping rates abnormally low (and real yields negative), the stimulus-related bump in inflation in 2023 caused central banks to move aggressively to rerate yields higher. This caused negative returns for existing holders of bonds, but we believe it also set the stage for strong performance from bonds going forward.

Why fixed income in 2023?

In our view, aggressive central bank action has created a potential buying opportunity in high quality fixed income in 2023. Government bond yields and real yields have risen sharply. In addition, credit spreads in many high quality fixed income asset classes have widened and are attractive, in our view. All-in yields in a number of high quality fixed income credit asset classes look as attractive as they have since the Global Financial Crisis of 2008. The period of suppressed yields that had prevailed since the Global Financial Crisis is over, and we believe bonds now offer a compelling income opportunity for investors.

In short, we believe the bond market holds the greatest potential that we’ve seen since the Global Financial Crisis, and there are compelling reasons for investors to take a closer look at this opportunity now.

1. Inflation has peaked, in our view. Inflation is the enemy of bond investors and was the root cause of negative performance of bonds in 2022. We expect inflation to decline in 2023 and should prove to be more of a tailwind than a headwind for bond investors in 2023.
2. Central banks have raised interest rates aggressively, and we believe they are very close to the end of their rate hiking cycles. Cyclical bond buying opportunities occur as, or just before, central banks stop a rate hike cycle. We are there now, in our view.
3. We do not believe higher yields have worked their way through all asset classes. Bond yields provide the discount rate used for valuations across all financial markets. Higher bond yields should require higher yields and lower valuations across all asset classes. While we have seen the full impact of the yield increases in the public bond markets, it may take time for the higher discount rates to make their way through the economy and less liquid private asset markets. Therefore, we are more optimistic about the opportunity in public bond markets right now, versus private markets.
4. We expect slow, below-trend global growth going forward, but do not expect a deep recession. Currently, there are few signs of large economic imbalances that would be likely to lead to the type of deep recession experienced during the Global Financial Crisis or the pandemic lockdown. We would expect slow growth, without a deep recession, to be favorable for high quality fixed income. This type of environment could lead to stable or declining interest rates and minimal default risk in high quality assets.
5. Investors have sold or avoided bond investments, and instead kept assets in cash. In fact, since the end of 2021, the industry has seen net outflows from bond exchange-traded funds and mutual funds in the US. Many investors are likely now underweight bonds. As interest rates stabilize, investors are likely to return to the bond market with much of this cash. As we see investor flows into bonds, this could be supportive of bond market liquidity and performance.

6. Investors hold a lot of cash and floating rate assets in aggregate. When central banks are aggressively raising interest rates, it makes sense to hold cash or floating rate assets whose interest rates will adjust in line with central bank rate increases. Investors appear to have done this, putting money into money market funds and floating rate assets. When central banks are close to the end of their rate hike cycle, however, it may make sense for certain investors to rotate back into fixed rate assets, such as high quality bonds. Redeploying this cash into bonds may be very supportive of bond market performance in 2023.

What bond opportunities do we like now?

1. Investment grade corporate bonds in the US and Europe

Investment grade corporate bonds currently offer yields rarely seen since the Global Financial Crisis. Investment grade bonds are high quality bonds issued by some of the largest global companies. Even in recessions and other periods of economic stress, defaults in investment grade corporate bonds are likely to be rare. The current yields on offer in these high quality assets represent strong income potential for investors with a high probability of capital return. Investment grade corporate bonds have tended to generate very strong returns in the year after central banks finish a rate hike cycle.³

2. Municipals

Municipal bond yields have reset higher in line with the overall market, despite a very strong fundamental backdrop for municipal issuers. Large outflows from retail investors who sold municipal bonds as prices declined may have set the stage for a strong rebound in municipals in the coming year, in our view. Municipal bonds come in two types, tax-exempt and taxable, which provide options for both retail and institutional investors.

3. Residential mortgage credit bonds

Valuations across several investment grade non-agency residential mortgage-backed security (MBS) sectors stand out as attractive currently: single-family rental bonds, non-qualified MBS senior bonds and Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac) senior credit risk transfer securities are all attractive on an absolute yield and relative yield basis, in our view, compared to investment grade corporates. Yields on AA and A-rated non-agency bonds can be found in the 6.0%-6.25% range.⁴ While selling related to mutual fund outflows negatively impacted this sector, among others, we expect the supply picture to continue to be very supportive to spreads, given high mortgage rates and lower production.

The next wave of bond opportunities to watch

1. Non-US and emerging market local bonds

As US yields have rerated higher and as the Fed has tightened financial conditions, the US dollar has strengthened and now looks somewhat overvalued against most other currencies, in our view. When central banks stop hiking and the current patch of somewhat below-trend growth passes, we would expect the US dollar to give back some of its recent gains, which may provide a tailwind for global debt, both developed and emerging market, measured in US dollars.

2. High yield corporate bonds

High yield corporate bonds offer much-improved yields and have benefited from the overall rise in real yields. The potential issue with high yield corporate bonds is that they are lower credit quality than the investment grade sector and are potentially more sensitive to a recession. Credit deterioration during a period of slow growth may be a headwind for high yield. We are looking for more clarity on the economic path through 2023 and the resilience of the global economy to fully analyze the high yield opportunity.