With interest rates on the rise, expect bonds to be back in fashion
It has been a while, but it looks like bonds are primed to be an attractive investment option for investors moving forward.
Last year, 2022, was one of the worst years for fixed-income investments on record. This was due to the rapid surge in interest rates we saw last year. Although negative years for bonds are not very common, they can occur.
Given the spike in interest rates, bonds reacted the exact way they were supposed to react. This is because bonds prices have an inverse relationship with interest rates; when rates go up, bond prices go down. In 2022 the Federal Reserve shifted its monetary policy and began raising interest rates to try and curb inflation.
Many investors expected rates to increase in 2022, but the size and speed of the rate hikes were unprecedented.
While last year was painful for bond investors, it has set the stage for higher income down the road. With inflation now appearing to be on the downswing, the bulk of the Fed's tightening cycle seems to be over, and the Fed is expected to end its hiking cycle sometime in 2023.
So here we are, after years of historically low yields, interest rates for fixed income investments are at their highest levels in over a decade. Short-term U.S. Treasury bonds are now paying over 4% and higher yields are available in other fixed income sectors with longer maturities.
The "income" is back in fixed income. Although there might still be additional rate hikes this year, the current high interest rates should help dampen any future volatility.
A slowing economy might help bonds as well. With increased interest rates, comes slower growth. Many economists are predicting a recession in 2023. This has been the most forecast recession in the past 50 years.
There is no guarantee we will have a recession. Recessions are very tough to predict. However, with slowing economic growth, inflation dropping and the possibility of a recession, the Fed might reverse course again and cut interest rates in the future to help fuel economic growth.
Remember, bond prices and interest rates have an inverse relationship so falling rates would produce price gains for bond prices on top of their already attractive yields. Bonds should offer some relief from volatile equity markets if a recession does occur.
Bonds can have several functions in a portfolio. They can be used to generate income. They can be used to preserve capital and they can be used to lower a portfolio's volatility.
Also, the bond market is large and diverse. There are many different sectors of bonds with varying credits and maturities. As with all investing, investors need to match their investments with their own personal goals, time horizon and risk tolerance. With proper guidance and due diligence, today's environment offers investors the ability to build out a portion of their portfolio in bonds which can offer attractive yields with low risk.
• John P. Daly is president of Daly Investment Management LLC, a Registered Investment Advisor. www.dalyinvestment.com.