USIG - Ring In The New Yield

Summary

• A brighter outlook for bonds in 2023 should help investors leave the past where it belongs.
• We think the Fed is nearing the end of its rate hiking cycle, so the coming year is likely to be kinder for bonds.
• Bonds with lower duration have lower sensitivity to interest rate changes, while higher-duration bonds have higher rate risk.

By Carolyn Barnette

The bottom line: Carpe diem, bond investors!

• Many investors are holding onto cash in the wake of the '22 snafu.
• Seize your day and take advantage of higher yields with lower interest rate risk.
• It's a great time to put cash to work and earn more on your money.

The Scottish poem often sung on New Year's Eve asks, "Should auld acquaintance be forgot and never brought to mind?" Well, negative bond returns are hard to forget. But a brighter outlook for bonds in 2023 should help investors leave the past where it belongs. Still, it's helpful to understand what happened to bonds over the past year. When interest rates finally lifted from their long-standing historical lows in mid-2022, duration was no friend to bondholders.

There's just no escaping the bond math. For every 1% increase or decrease in interest rates, a bond's price will change by approximately 1% in the opposite direction for every year of its duration. Therefore, bonds with lower duration have lower sensitivity to interest rate changes, while higher-duration bonds have higher rate risk.

The Bloomberg U.S. Aggregate Bond Index, a measure of the investment grade bond market, began 2022 at very low yield levels - under 2% - and by year end, those yields had more than doubled, pushing above 4%. This sizeable rate move (?2%) caused the index, having an average duration of roughly 6.5 years, to decline by 13% over the year.

Bond math took its toll on investors in 2022

New year, new yields

As we head into 2023, higher yields offer two big advantages for bond investors:

1. More income. New bonds are paying coupons above 4%, compared to 2% one year ago.

2. Less risk. Less room for interest rates to rise means less room for bond prices to fall.

We think the Fed is nearing the end of its rate hiking cycle, so the coming year is likely to be kinder for bonds. Even if we were to see additional rate movement, though, the higher level of coupon income today would likely offset negative price action materially in long-duration bonds and entirely in short-duration bonds.

Higher yields in 2023 provide a cushion for unexpected rate moves

Annual total return (price return + coupon income)

Yield is represented by yield to worst, a measure of the lowest possible yield that can be received on a bond that fully operates within the terms of its contract without defaulting. U.S. 1-3yr Treasury refers to the Bloomberg US Treasury 1-3yr Index. U.S. 1-3yr Investment Grade refers to the Bloomberg US Corporate 1-3yr Index. U.S. Aggregate Bond refers to the Bloomberg U.S. Aggregate Bond Index. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

If your New Year's resolution is to gear towards capital preservation, stick with short-duration Treasury or investment-grade corporate bonds. With yields currently over 4% and 5%, respectively, these assets can withstand more than a 1% move in interest rates and still generate a positive return.

Investing involves risks including possible loss of principal.

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This post originally appeared on the iShares Market Insights.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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