Fixed Income investors will be glad to see the back of 2022. Surprisingly, high inflation caught both policymakers and investors off guard last year and the subsequent tightening in monetary policy certainly took its toll on bond prices. But how bad was 2022 versus history?
The below chart shows the scale of the decline, as the Bloomberg U.S Aggregate Index returned -13.01%, its biggest drawdown in the history of the index. While the size of the decline certainly makes for painful reading, the gap between last year’s return and the second-worst-performing year, in 1994, is even more alarming. 1994 was a particularly turbulent year which included ‘The Great Bond Massacre’, a sudden decline in bond prices which wiped out $1.5 trillion in market value, as well as the Mexican Peso Crisis that triggered a global currency crisis. Despite these challenging conditions, the Bloomberg U.S Aggregate returned -2.9% in 1994, a significantly smaller drawdown than what investors experienced last year. This places into context quite how challenging 2022 was for fixed-income markets.
Figure 1: Year-to-Date Returns for Bloomberg U.S. Aggregate Index by Calendar Year
Source: Barclay’s Live, data as of December 30, 2022
So what might this year have in store for weary bond investors? As we discussed in our Investment Quarterly, recession remains our base case this year with a probability of 60%; however, there is cause for cautious optimism amongst long-term investors given a number of potentially positive catalysts in 2023. China, who’s economy accounts for over 18% of global GDP, is gradually reopening following a relaxation of its Zero COVID policy. In the US, while the Federal Reserve (the Fed) may still be hiking interest rates to combat above-target inflation, a number of these potential rate hikes are already priced in by market participants. This investor expectation of further rate hikes should mitigate some of the headwind for bond prices in 2023.
As the economic picture shows some signs of brightening, another important feature is the recovery in bond valuations. At the start of 2022, the Bloomberg U.S Aggregate offered a yield-to-worst of 1.8%. As of December 31, 2022 the same index offered a yield of 4.7%, its highest level since late 2008. While there are undoubtedly obstacles to be navigated in 2023, more attractive bond valuations offer investors a more reasonable level of compensation for taking on these risks. For long-term investors returning to fixed-income markets, the starting yield on bond benchmarks is often a reasonable precursor for annual overall returns over long time periods. As Figure 2 highlights, higher starting yields typically lead to higher bond market returns over time meaning that the yields on offer today provide a more attractive entry point into the bond market versus recent history.
Figure 2: The Relationship between Starting Yield and Annualized Return by Year
Source: Bloomberg, data as of December 30, 2022
Investors should be conscious that fixed-income markets are likely to move quickly in the coming months. Historically, bond yields peak prior to the last interest rate hike and then decline very quickly. As investors will not want to miss the boat, any backups in bond yields in the early month of 2023 should be used to add high-quality duration exposure to portfolios in 2023.
