Compared to the past decade, bond yields across every major sector are above their ten-year median.
Bonds have had a strong start to the year after a tumultuous 2022. But with the Federal Reserve (Fed) still talking tough on inflation, investors are concerned if this bond rally is sustainable. We recently launched our Bonds are back series, which make the case for bonds in the current environment. To summarize, there are five key considerations for bond investors in 2023:
- Bond returns tend to be quite strong after down years. Since 1976, in the years following bond market declines, the average return has been 11.5%.1
- Inflation is showing clear signs of cooling further. Recent months of inflation data provide strong evidence that core goods and energy prices are declining. Moreover, shelter inflation should begin softening by the middle of the year.
- With early signs of softening in the economy, the Fed can be less aggressive with rate increases. A recession crystalizing sometime this year seems to be consensus and incoming manufacturing data and other leading indicators of activity suggest the economy is indeed coming under pressure.
- Valuations reset significantly in bonds last year, making an attractive entry point for investors. Relative to the past 20 years, bonds look outright cheap with valuations in US Treasuries and core bonds a standard deviation below their long run average.
- Current bond yields are attractive relative to recent history. Compared to the past decade, bond yields across every major sector are above their ten-year median. Importantly, current yields are a good predictor of future returns suggesting better returns may lie ahead.
For investors, it is important to take advantage of what could be a small window of opportunity. Given both inflation and growth are decelerating and the potential for a more cautious Fed, bonds yields could decline this year, boosting total returns in core bonds.
1The Bloomberg U.S. Aggregate had negative total returns in 1994, 1999, 2013 and was flat in 2018. Average returns are based on calendar year returns for the Bloomberg U.S. Aggregate in 1995, 2000, 2014, and 2019.