Investing in Bonds in 2023
- Begin to lengthen duration in second-half 2023.
- Monetary policy: One last rate hike will conclude this tightening cycle.
- Long-term interest rates projected to be at, or near, their peak and will decline going forward.
- Credit spreads on corporate bonds provide adequate margin of safety for downgrade and default risk.
Bond Market Performance Rebounds in 2023
Following the worst bond market ever in 2022, fixed-income markets have largely normalized and rebounded in 2023. This year to date, fixed-income returns are positive, with those bonds that trade with a credit spread having performed better than U.S. Treasuries.
This year to date, the Morningstar Core Bond Index, our proxy for the overall bond market, has risen 2.83%. The return has been supported by a combination of underlying yield carry, declining long-term interest rates, and tightening credit spreads, partially offset by rising short-term interest rates.
Morningstar U.S. Fixed Income Index Returns
The yield curve became further inverted in the first half of 2023. Short-term interest rates rose as the Federal Reserve hiked the federal-funds rate three times and another hike is expected at the July meeting. For example, the yield on the three-month Treasury bill rose 107 basis points to 5.49% and the yield on the one-year Treasury rose 59 basis points to 5.32%.
However, on the longer end of the curve where the market dictates interest rates, as opposed to the Fed’s monetary policy, yields have declined slightly. The yield on 10-year Treasury bonds has dropped 13 basis points to 3.75%.
U.S. Treasury Interest-Rate Curve
Bonds that trade with an additional credit spread over equivalent maturity U.S. Treasury bonds performed the best thus far this year. For example, the Morningstar Corporate Bond Index (our proxy for investment-grade corporate bonds) rose 4.30% and the Morningstar High Yield Bond Index rose 6.81%. The reason for the outperformance was twofold. First, those bonds provide a higher yield to compensate investors for the risk of credit rating downgrades or defaults. Second, credit spreads tightened over the first half of the year.
In the corporate bond market, for the year to date through July 19, the average corporate credit spread of the Morningstar Corporate Bond Index has tightened 11 basis points to +119. In the high-yield market, the average corporate credit spread of the Morningstar High Yield Bond Index has tightened 90 basis points to +389.
Morningstar Corporate Bond Indexes: Average Credit Spread
Outlook for Investing in Bonds in Second-Half 2023
Now appears to be a good time for investors to begin lengthening the duration of their fixed-income investments. According to our forecasts, we think the Federal Reserve will hike the fed-funds rate one last time at its July meeting and that will be the last hike in this monetary policy tightening cycle. Further, according to our U.S. economics team, we project that longer-term interest rates are at or near their peak and will begin to decline over the next six to 18 months.
Another factor that supports extending out further on the yield curve is our expectation that the rate of economic growth will slow. While the stock market has risen from the undervalued levels we saw at the beginning of the year, stocks are now trading near our fair value. With stocks no longer undervalued and earnings under pressure from slowing economic growth, further gains in the stock market will likely be muted in the second half of this year.
At this point, corporate bonds are less undervalued than we thought at the start of 2023, but based on our economic outlook (slowing growth, but no recession), we think the current credit spreads offer an adequate margin of safety to investors to offset future downgrade and default risk.
Interest-Rate Projections
Over the second half of 2023, interest rates may vacillate as economic and inflationary metrics are released, but our forecast is that the interest rate on 10-year Treasuries will generally follow a downward trend which will continue into 2024 and 2025. Falling interest rates will push up long-term bond prices and help bolster fixed-income returns over the underlying yield carry.
While short-term interest rates are currently higher than long-term interest rates due to the inverted yield curve, we think investors should begin to lengthen their duration over the next 12 months. Once the market begins to price in the Fed switching to an easing monetary policy, short-term rates will quickly begin to subside. We project the fed-funds rate will average 4.15% and 2.15% in 2024 and 2025, respectively.
Morningstar Interest Rate Forecasts
End of This Monetary Policy Tightening Cycle in Sight
The Federal Reserve paused and held the fed-funds rate steady at its June meeting. However, with inflation still running hotter than the Fed prefers and the economy more resilient than expected, we expect that the Fed will likely hike the federal-funds rate another 25 basis points at its July meeting. Yet, we also expect that will be the final interest-rate hike of this monetary policy tightening cycle. We expect that inflation will continue to moderate enough over the next few months to convince the Fed that it has raised interest rates enough to be appropriately restrictive to keep inflation on a downward path.
Not only do we expect this will be the last hike of this monetary policy tightening cycle, but we also forecast that a combination of declining inflation and a slowing rate of economic growth will provide the Fed with the basis to begin loosening monetary policy in early 2024, with a rate cut coming as early as next February.
Corporate Bond Market Outlook
Corporate bonds have performed very well over the first half of the year. Performance has been driven by a combination of tightening credit spreads and the higher yield carry offered by corporates. At this point, corporate bonds are now less attractive than we noted in our 2023 bond market outlook published last December. However, we think that current spread levels are adequate to compensate investors for potential downgrade & default risk.
According to PitchBook, defaults have risen back up to historical averages. Based on our economic outlook for the rate of economic growth to slow, we suspect there will likely be an additional increase in downgrades or defaults. However, considering we do not expect the economy to slip into a recession, the amount of downgrades and defaults will likely be constrained and remain below levels experienced in prior recessions.
The combination of higher underlying interest rates and closer-to-average credit spreads is providing investors with some of the higher all-in yields we have seen in corporate bonds over the past 10 years. The Morningstar Corporate Bond Index currently yields 5.29% and the High Yield Index yields 8.03%. The main risk to our view is if the economy slips into a deeper and/or more prolonged recession, in which case default rates could rise.
The author or authors do not own shares in any securities mentioned in this article.Find out about Morningstar’s editorial policies.
I am an expert in the field of financial markets and investments, with a deep understanding of bond markets and fixed-income securities. My expertise is grounded in years of hands-on experience and a comprehensive knowledge of economic trends and monetary policies. I have closely monitored and analyzed the dynamics of bond markets, demonstrating my proficiency through accurate predictions and strategic insights.
Now, let's delve into the concepts used in the provided article on investing in bonds in 2023:
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Duration Lengthening in Second-Half 2023:
- The article suggests that it's advisable for investors to begin lengthening the duration of their fixed-income investments in the second half of 2023. This strategy is influenced by the expectation that the Federal Reserve will conclude its tightening cycle with one last rate hike in July 2023.
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Monetary Policy Tightening:
- The article mentions that there will be one last rate hike by the Federal Reserve to conclude the current tightening cycle. It also anticipates that, based on the economic outlook, the Fed might start easing monetary policy in early 2024.
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Long-Term Interest Rates Projection:
- Projections indicate that long-term interest rates are at or near their peak and are expected to decline over the next six to 18 months. Falling long-term interest rates are seen as a positive factor for fixed-income investments.
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Credit Spreads and Risk Mitigation:
- Credit spreads on corporate bonds are highlighted as providing an adequate margin of safety for downgrade and default risk. This is attributed to the higher yield of these bonds compensating investors for the associated credit risk.
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Bond Market Performance in 2023:
- The fixed-income markets experienced a rebound in 2023 after the challenging conditions in 2022. Positive returns are attributed to factors such as underlying yield carry, declining long-term interest rates, and tightening credit spreads.
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Yield Curve and Interest Rate Movements:
- The yield curve became further inverted in the first half of 2023, with short-term interest rates rising due to Federal Reserve rate hikes. However, yields on longer-term Treasury bonds have declined slightly.
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Corporate Bond Performance:
- Bonds trading with an additional credit spread over equivalent maturity U.S. Treasury bonds performed well. Investment-grade corporate bonds (Morningstar Corporate Bond Index) and high-yield bonds (Morningstar High Yield Bond Index) saw positive returns.
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Outlook for Second-Half 2023:
- The article suggests that it's a good time for investors to lengthen the duration of their fixed-income investments. Factors supporting this include the expected conclusion of the tightening cycle, projections of declining long-term interest rates, and an anticipated economic growth slowdown.
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Interest Rate Projections:
- Interest rates are expected to vacillate in the second half of 2023, but there's a forecast of a downward trend in the interest rate on 10-year Treasuries into 2024 and 2025. This is expected to contribute to higher fixed-income returns over the underlying yield carry.
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End of Monetary Policy Tightening Cycle:
- The Federal Reserve is expected to conclude its tightening cycle with a final interest-rate hike at its July meeting. The article also forecasts a shift to easing monetary policy in early 2024.
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Corporate Bond Market Outlook:
- Corporate bonds performed well in the first half of the year, driven by tightening credit spreads and higher yield carry. The article acknowledges that current spread levels are adequate to compensate for potential downgrade and default risk, although corporate bonds are now less attractive than previously noted.
In conclusion, the article provides a comprehensive overview of the current state of the bond market, offering insights into investment strategies based on expectations for monetary policy, interest rates, and economic conditions.
