So far this year, we've seen a challenging start for fixed income investors. Rising interest rates caused prices for previously issued bonds to fall throughout the first quarter and into April, which led to declines for most fixed income sectors. As a result, many investors have been questioning what caused the selloff and what lies ahead. But, despite the rough start, there are reasons for optimism. Let’s look at what triggered the selloffs and why the rest of the year may offer opportunities for fixed income investors.
Markets Follow the Fed
The major driver for the negative performance to start the year was rising interest rates. This market environment was largely due to growing investor expectations for Fed rate hikes in 2022 and 2023 to combat the high levels of economic inflation. The Fed spent much of this year's first quarter convincing investors of its commitment to taking inflation seriously and implementing a faster tightening cycle than we’ve seen in the past. The markets listened and adjusted rates accordingly.
At the start of the year, the markets were projecting a total of three interest rates hikes of 25 bps each. Since then, we’ve seen expectations for additional hikes get quickly priced into markets, as high inflation and a strong labor market caused the Fed to tighten policy faster than expected.
We ended last week with markets pricing in a total of nine hikes in 2022. They would bring the federal funds rate up from virtually 0 at the start of the year to nearly 2.5 percent at year-end. Looking further out, the Fed expects to see the federal funds rate peak at 2.75 percent in 2023 before falling back toward the central bank’s longer-term target of roughly 2.5 percent in 2024 and beyond.
At this point, markets are largely pricing in the expected Fed hikes for the rest of the year. From here, it’s unlikely that we'll see rates increase significantly in response to the Fed’s tightening plans.
Returns Varied by Sector
While rates rose across the board in the first quarter of 2022, fixed income returns were mixed across sectors, with longer maturity bonds seeing larger selloffs. As a reminder, longer maturity bonds typically have higher interest rate risk than shorter maturity bonds, which can cause them to suffer from larger price drops in a rising rate environment.
For example, long Treasury bonds are down by more than 17 percent year to date, while short Treasury securities have held up much better. The Bloomberg Short-Term Treasury Index is down by less than 1 percent so far in 2022. The Bloomberg US Aggregate Bond Index, which is an intermediate-term index of investment-grade bonds, split the difference and is down roughly 8.5 percent. Most intermediate sectors have experienced similar declines to that of the Bloomberg US Aggregate Bond Index this year.
Other areas that held up relatively well include short-term corporate bonds and the bank loan sector, both of which are down by less than 1 percent year to date. These sectors are lower duration than typical intermediate- to long-term bond sectors, which largely explains the better relative performance.
Ultimately, the price declines for most intermediate- and long-term bonds this year are a powerful reminder that diversification remains essential when putting together fixed income allocations.
Silver Lining of Rising Rates
There is good news for fixed income investors. Historically, the majority of total return for fixed income comes from the income return you receive when you reinvest coupon payments. Price return, on the other hand, has only accounted for a small portion of total return over the intermediate to long term. It’s the price return that has caused the underperformance.
Given the importance of reinvesting income for total return, rising rates can lead to higher total return expectations for bonds over the intermediate to long term since that income can be reinvested at higher rates. With higher rates for reinvestment and much of the Fed’s anticipated hikes already priced into markets, we expect to see most fixed income sectors show improvement throughout the rest of 2022.
The potential for short-term volatility still exists, however. If inflation remains stubbornly high, it could lead to more aggressive Fed action than currently expected. We may also see markets negatively react once the Fed gives more details on the expected path and pace of its balance sheet reductions set for later in the year.
A Positive Outlook
Even with these risks, our outlook for fixed income going forward remains more positive than it has been so far. That’s not to say we expect to see intermediate- and long-term sectors claw back the recent price declines immediately. But with less price pressure from rising rates and the ability for reinvestment at higher rates during the year, we can expect to see improvements by year-end.