Print
Throughout 2022, high levels of volatility across all major asset classes created a difficult environment. Fixed income investors were hit especially hard, as rising yields—brought on by surging inflation—weighed heavily on bond prices. Although not ideal, this helped set the stage for a more positive start to 2023.
In the first half of the year, virtually all major fixed income sectors experienced positive returns. Those returns were supported, in part, by falling long-term yields. Bond prices (which move inversely to yield) rallied during periods of uncertainty—most notably in March and April amid concerns about the health of the banking industry. Historically, bond prices have tended to rise in tandem with market risk, as investors seek the relative safety of fixed income. So, the fact that bonds started acting like bonds again was encouraging.
The outlook for fixed income investors in the second half of the year is still positive. While we have seen yields come down a bit, they are still attractive historically. And while there are some compelling options across several sectors, it’s important to remember that not all fixed income behaves the same way.
U.S. Treasuries Look Attractive Amid Fed Inflation Fight
U.S. Treasury securities have been a popular choice for investors this year. A combination of higher short-term rates and the relative safety that comes with government-backed debt has helped spur demand.
Short-term rates have risen, in large part, because of additional rate hikes from the Fed, as the central bank tightened policy in the first half of the year to combat inflation. At the end of June, the upper target on the federal funds rate was 5.25 percent following three 25-basis-point hikes in February, March, and May. This slowdown in the Fed’s tightening cycle helped put pressure on inflation without causing market declines.
We’re seeing encouraging signs that the worst is likely behind us. After peaking at 9.1 percent last June, year-over-year consumer inflation came in at 4 percent in May. If we continue to see progress in the Fed’s fight again inflation, Treasuries at current yield levels would be an attractive choice for investors.
Company Fundamentals a Key Factor for Corporate Bond Performance
Investment-grade corporate bonds can provide more yield compared with Treasuries without presenting too much additional credit risk. Investment-grade corporate bonds were paying a spread of approximately 130 basis points at the end of June. This means that investors in corporate bonds, on average, are receiving yields roughly 1.30 percent higher than investors in comparable maturity Treasuries.
While higher yields can be compelling, corporate bonds may be subject to more volatility than Treasuries if corporate fundamentals deteriorate. Because corporate bonds are backed by the health of their corporate issuers, fundamentals like profitability, debt, and growth potential can be major drivers of long-term performance and should be considered when making allocations.
That said, the economic data continues to paint a relatively positive picture, which should help support company fundamentals for investment-grade corporations.
High-Yield May Underperform if Economy Slows
While investment-grade corporate bonds may provide a relatively attractive yield pickup for investors comfortable with additional credit risk, high-yield corporate bonds are another story. While high-yield bonds do offer relatively higher yields compared with investment-grade corporates or Treasuries, they also tend to be more economically sensitive. Their lower credit quality means that they can be more volatile during times of economic slowdown.
If we do see a further slowdown in economic activity in the second half of the year, high-yield bonds may underperform.
Solid Tax Revenues Support Municipal Bond Space
There are also several potential opportunities for investors in the municipal bond space. While each investor’s tax situation and financial plan are unique, in general, municipal bonds may make sense for investors in the top marginal federal income tax bracket.
Fundamentally, municipal bonds are in good shape due to solid tax revenues, as well as the unprecedented amount of stimulus that municipalities received from the federal government during the pandemic. This should help support investors in this historically high-quality asset class.
Compelling Options for Investors
Ultimately, no matter how investors choose to gain exposure, there are relatively compelling options across most major fixed income sectors. We’ve seen positive signs that bonds are back to acting like bonds in times of uncertainty. Further, long-term yields are still attractive despite the modest drop we’ve seen so far this year.
While it’s important to match investors’ risk tolerance and time horizon to their allocations, bonds deserve consideration in a well-diversified portfolio designed to pursue long-term goals.
To access our full 2023 Midyear Outlook, click the Get It Now button in the sidebar to your right.
Bonds are subject to availability and market conditions; some have call features that may affect income. Bond prices and yields are inversely related: when the price goes up, the yield goes down, and vice versa. Market risk is a consideration if sold or redeemed prior to maturity. Corporate bonds contain elements of both interest rate risk and credit risk. Municipal bonds are federally tax free but may be subject to state and local taxes, and interest income may be subject to federal alternative minimum tax (AMT).
