After a difficult year in 2022, some investors have been asking: what lies ahead for the fixed-income market?
Modern portfolio theory has been built upon the premise that portfolio risk can be reduced through diversification — investing in assets that have low positive correlation or even negative correlation. Typically, stocks and bonds have had negative correlation — when the stock market falls, bonds provide safety.
However, in 2022, the stock/bond correlation turned positive, and both asset classes experienced significant declines. This prompted the question: Is the 60/40 portfolio dead? Regardless of the percentage of a portfolio’s allocation to equities and fixed income — 60/40 or 70/30, as examples — last year’s situation demonstrated that diversification isn’t always a sure thing.
Yet, consider that 2022 was largely an anomaly. The central banks aggressively raised interest rates to fight inflation — much faster and higher than many market participants expected. As a reminder, as interest rates rise, bond prices generally fall. And, since bonds started 2022 with such historically low yields, this led to significant volatility and repricing of the bond market.
Consider that since 1929, there have only been three calendar years when stocks and bonds were both down in the U.S. — it’s quite rare to see both decline in the same year (see Table 1).
So, Where to For Fixed Income?
After many years of artificially low interest rates, yields needed to reset to higher levels. Last year saw a substantial adjustment within a very short period of time, which led to the significant repricing. However, history has shown that this variability generally smooths out. A look back at the returns for 10-Year U.S. Treasuries following large down years shows this mean reversion (see Table 2).*
As well, higher yields and the potential for lower volatility are expected to support fixed-income markets. At the time of writing, inflation continues to show signs of easing and the pace of policy rate increases appears to be slowing. Of course, prices could be driven lower and yields higher if economic conditions or fundamentals dramatically change, though it is unlikely we will experience hawkish surprises from the central banks similar to what we saw in 2022. Even if prices do remain volatile in the short term, consider that yields are now at highs not seen in decades.1 Higher income, through increased yields, contributes to supporting total returns over time.2
- At the time of writing. Yields are “above the 20 year average and roughly in line to….the 30 year average for bond yields based on major indices”: https://www.pimco.ca/en-ca/resources/video-library/media/bonds-are-back-the-3-fs-pressure-points-and-moderating-inflation; 2. If we are, indeed, returning to an environment of higher yields, the traditional benefits of capital preservation, income and diversification should not be overlooked.
Table 1: Years When Both Stocks & Bonds Declined
Table 2: 10-Year U.S. Treasury Worst % Returns Since 1928
* It should be noted that interest rates were higher in many of these periods than they are today, which helped to bolster the impressive returns of the 1980s and 1990s.