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After a terrible year for bonds, the outlook is better


October capped their worst 12-month period ever for bonds, and the economy is under pressure. Yet the fundamental math of bond returns bodes well for 2023, Jeff Sommer writes.

By Jeff Sommer


This has been an awful year for U.S. bonds — so bad that 2022 may end up as the worst calendar year in history.


But what do the terrible bond returns in 2022 mean for the future?


Recall the old warning: Past performance doesn’t guarantee future returns. That’s emphatically true now for bonds.


These past poor returns definitely don’t imply that you should avoid bonds now. With some caveats, which I’ll come back to, the fundamental math of bond returns suggests that 2023 will be much better than 2022.


At the very least, a repetition of the shocking level of the losses of 2022 isn’t likely. What’s more, after the big downturn of the last year, a major rebound is certainly possible.


“The prospects for long-term Treasuries are looking very good right now,” said Michael Contopoulos, director of fixed-income strategy at Richard Bernstein Advisors. He presents a reasonable argument that they could turn out to be the best asset class — better than stocks or commodities — of 2023.


I wouldn’t buy bonds, or any other asset, as a speculative bet. But for long-term investors, the basic reasons for buying bonds — solid value and reasonable yields — are becoming evident again.


“Yields have already risen a lot over the last year,” said Mary Ellen Stanek, managing director of Baird Asset Management in Milwaukee. “It’s been a rough stretch, but we think bonds are back.”


Until this year, bonds were often thought of as Steady Eddies: boring investments that could be counted on for stability and steady income. In 2022, however, as inflation and interest rates have soared, the bond market has been anything but reliable.


In fact, the 12 months through October ranked as the worst ever recorded, and the 12 months through November were almost as bad, according to Edward McQuarrie, an emeritus professor in the School of Business at California’s Santa Clara University, who has compiled U.S. bond returns going all the way back to 1794.


“Basically, it’s never been worse than the last year,” he said in an interview.


The fundamentals


Bonds are loans made by investors who, in return, receive regular income, known as yield. Market yields have already risen appreciably.


Bond returns — in an actively traded portfolio of individual bonds or in a mutual fund or an exchange-traded fund — come from a combination of yield and price changes. When yields rise, bond prices fall, and vice versa. That’s fundamental bond math.


These price effects are much greater for bonds of longer maturity — more precisely, bonds of longer duration, an important measure of interest rate sensitivity. This means that the price of a 30-year Treasury bond will move much more than the price of a three-month Treasury bill in response to the same interest rate shift.


Think of it this way: When the market interest rate rises to 4% but you own a security that pays you 3% in income, your security will lose some of its market value. For a security that will keep paying an inferior interest rate for 30 years, the loss is much greater.


This disparity is why the rising interest rates of the last year have been wonderful for short-term fixed-income investments and awful for those of longer term.


Longer-term prospects


Rising yields may not be a problem if you buy a security for the income it provides and hold it until it matures. But if you trade a portfolio of bonds or hold shares in a bond mutual fund or an ETF, falling bond prices can outweigh the benefits of rising yields. That is what happened this year.


But now that yields are already fairly high, the outlook is different.


“Based on history, a year from now I don’t think we’re likely to have had another year with losses like the last one,” McQuarrie said.


Right now, bonds provide much greater income than at the beginning of the year, and that will provide at least a partial shield against the negative effects of any further increases in interest rates.


The basic argument of bond bulls is that at some point over the next year, interest rates will stabilize and then turn downward, because inflation will be under control and the economy will be slowing. Falling rates would drive up bond prices.


If you adhere to this outlook, it makes sense to lock in higher bond yields fairly soon.


Potential problems


That said, it would by no means be surprising if bond market yields instead rose from here, causing further losses in bonds and bond funds. Odds are that such losses would be minor and more than offset by the income from higher yields. But there could well be some rocky months ahead.


On the other hand, the outlook would be much worse if inflation turned out to be intractable, the economy didn’t slow fairly soon in response to higher interest rates, and the Fed’s struggle to curb the rate of price increases persisted for years rather than months. Under those circumstances, longer-term interest rates could rise substantially, producing further declines in bond prices.


“I think the chances of that happening — and of there being further big losses in bonds — are pretty low over the next year,” said Kathy Jones, chief fixed income strategist for the Schwab Center for Financial Research. “Yields are already high enough that the outlook is quite good.”


Still, among the most troubling of foreseeable problems is this: Republicans in Congress are threatening to use the federal debt ceiling as a weapon in their negotiations with Democrats about spending and the budget. Congress will need to raise that ceiling before the government’s total borrowing reaches its current statutory limit. That’s expected to happen sometime in the summer or autumn of 2023.


In the current partisan climate, it is easy to imagine toxic brinkmanship that would disrupt the bond market and may do much more damage than that.


As I wrote back in 2011, Treasuries are the linchpin of the entire global financial system, and tampering with them could have dire, far-reaching consequences.


Precisely because breaching the debt ceiling could be so consequential, most bond analysts assume it won’t happen.


There are other problems, too. Insufficient trading volume — or liquidity — in the Treasury market because of a complex series of changes in the marketplace over the last decade or two poses another threat. The Fed and the Treasury intervened successfully in past episodes, in which the lack of willing participants during financial panics magnified wild swings in the prices of bonds and of the funds that hold them. I assume the government will intervene again as needed.


Still, those caveats aside, I remain reasonably optimistic about bonds over the next year or two.


Every investor should hold a diversified selection of bonds. With a little bit of luck, owning them won’t be painful, and may even bring substantial satisfaction, in 2023.


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