Key Questions: What Does 2023 Hold for Bonds?

Rajeev Sharma, Managing Director Fixed Income

<p>Key Questions:&nbsp;What Does 2023 Hold for Bonds?</p>

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If the economy slows and inflation peaks, the opportunity to earn yields in fixed income could be significant.

Rate hikes and tighter financial conditions drove fixed income returns lower in 2022, producing one of the worst periods in history for the fixed income markets. The surge in yields across the yield curve was the result of an aggressive Federal Reserve (the Fed), which remains committed to using monetary policy to combat the highest inflation readings in the past 40 years.

In 2023, we anticipate that the Fed will slow the pace of rate hikes but monetary policy will remain restrictive for most of the year. The terminal Federal Funds Rate (the rate at which the Fed is expected to stop raising rates) is projected to be around 5%. Therefore, the market is expecting another 1% in rate increases through mid-year 2023.

The driver of fixed income performance will shift from rate increases to the state of the economy, with a potential recession looming for this year. As the economy slows and inflation peaks, the opportunity to earn yields in fixed income is significant.

Bonds are viewed as safe haven assets and typically outperform other investments in recessionary periods. Central banks also often lower interest rates during economic slowdowns to encourage spending.

This, in turn, would move bond prices higher and fixed coupon payments will start to look attractive relative to falling interest rates. In addition, equity-like returns can now be realized in certain fixed income asset classes.

As yields surged through 2022, there are now attractive total return opportunities in fixed income. Fixed income asset classes are more fairly priced than they have been in over a decade. The 2-year Treasury note is yielding 4.27% while investment-grade corporate bonds are yielding close to 6%. The risks associated with an economic slowdown keep us focused on the up-in-quality trades with credit selection being of paramount importance.

With Treasury yields at higher levels, it makes sense to remain shorter in duration, particularly if the US economy is likely to enter a recession in the first half of 2023. Value can be achieved by investing in Treasuries and investment-grade securities.

The Case for Investment Grade-Securities

Credit spreads widened throughout 2022 and are at attractive levels, creating opportunities for investment-grade bonds. Overall yields are also very attractive given the rise in Treasury yields. Corporate bond issuers are well-capitalized with strong balance sheets, which can provide resiliency through a recessionary environment.

Short-maturity investment-grade bonds, in particular, are offering yields above 5%. With flat credit curves, it is advantageous to invest in shorter-maturity corporate bonds. These securities should remain insulated from widening credit spreads during an economic downturn, given their low sensitivity to price changes and their high degree of income generation.

With higher yields, we expect a slowdown in new issuance for investment-grade corporates in 2023. This will provide technical support to the corporate bond market, providing a strong case for tighter bond spreads.

Key Takeaways

Bonds were not always a reliable safe haven during 2022 as rate hikes and tighter financial conditions drove fixed-income returns lower. But as the economy slows in 2023, fixed income assets should provide some opportunities for investors.

Recession risks will rise as the Fed’s monetary policy continues to work toward combating inflation. While corporate spreads widened in 2022 from very tight levels, valuations are not yet at levels that reflect recession expectations.

Therefore, we recommend retaining a defensive stance that favors high-quality, short-duration investment-grade corporate bonds over high-yield securities. We also believe that allocating to short Treasuries is a viable cash management solution. Untenable inflation is the main risk to fixed income because it would force the Fed to continue raising rates, putting pressure on absolute rates and further restricting financial conditions.

For more information, please contact your advisor.


Rajeev Sharma Biopic

About Rajeev Sharma

Rajeev Sharma is Managing Director of Fixed Income Investments at Key Private Bank. In this role, Rajeev is responsible for overseeing and managing Taxable and Tax-exempt Fixed Income investments, including common trust funds, institutional model strategies and individual fixed income portfolios for both institutional and high-net-worth clients.

Rajeev has 20 years of Fixed Income experience. Prior to joining KeyBank, he was Head of Fixed income at Foresters Investment Management Company. He served as the chief corporate bond strategist and lead portfolio manager responsible for all corporate bond exposure across the mutual fund and life insurance suite of products. As Director of Fixed Income and overseeing managed fixed income and money market funds he was instrumental in launching a short duration bond strategy, co-manager on the Limited Duration Bond Fund, and the Total Return Fund, a mixed asset allocation fund.

Rajeev also brings prior experience as senior credit analyst at Lazard Asset Management, and associate director of corporate ratings at Standard & Poor’s Rating Services.

Rajeev received his Bachelor of Science degree in Electrical Engineering from Drexel University, a Master of Science degree in Electrical Engineering from the University of Pennsylvania, and an MBA from Cornell University.

The Key Wealth Institute is comprised of a collection of financial professionals representing Key entities including Key Private Bank, KeyBank Institutional Advisors, and Key Investment Services.

Any opinions, projections, or recommendations contained herein are subject to change without notice and are not intended as individual investment advice.

This material is presented for informational purposes only and should not be construed as individual tax or financial advice.

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