Stocks are off to a quick start in 2023, the S & P 500 ahead by 3.5%. Yet boring old bonds have just about kept pace, as investors rush to lock in healthy-seeming yields after one of the worst years ever for fixed-income returns. More than $38 billion in net new money has flowed into bond funds in less than three weeks this month, amounting to a hefty 0.6% of their collective assets under management and nearly quadrupling the intake of equity funds over that span, according to EPFR Global. “Bonds Are Back,” declared Barron’s this month, echoing a sentiment voiced by an ongoing parade of CNBC guests and portfolio managers, including Doubleline Capital founder Jeffrey Gundlach, who called the bond market “exciting” at the dawn of the year and recommended investors consider a 40/60 portfolio, inverting the traditional asset mix in favor of bonds. TLT YTD mountain iShares 20+ Year Treasury Bond – Year-to-date On some level, this all makes perfect sense. The Federal Reserve’s historically aggressive tightening campaign last year gouged debt portfolios but quickly rebuilt the supply of safe yield on offer for today’s buyers. Shorter-term Treasuries above 4% and investment-grade corporates above 5% look generous to investors accustomed to minimal coupons for years. Meanwhile, the Fed, by most accounts and the market’s estimation, is coasting to the likely finish of its rate-hiking business, and a Fed pause is typically friendly for bond values. And given the justified concern about the chances of the economy sputtering into a recession over the coming year, bonds’ role as a potential offset to any further stock-market setbacks is that much more relevant. All this means bonds can serve their intended purpose of dampening portfolio volatility, creating an income cushion and enabling investors to shoulder more risk as they seek greater reward from their equity allocations. I made the case for bonds’ value from this perspective in a column here three months ago, just as Treasury yields were peaking. How much value left in bonds? Still, with the growing consensus in favor of debt securities and with the yield on the iBoxx US Corporate Bond Index down from 6.4% to 5.1% since late October – at a time when Fed officials are trying to persuade Wall Street that short-term rates will go above 5% and stay there for a while – it makes sense to ask if much value remains in the asset class. There’s at least some sense that the relative novelty effect of having 4-6% nominal yields to capture has made some investors more excited for fixed-income than they otherwise would. The good news is that “real yields,” meaning yields above the market’s implied outlook for inflation, remain positive. In other words, owners of Treasuries are being compensated a bit in real terms for financing the government — unlike most of the previous decade when real yields were negative. Renaissance Macro Research has a model to gauge value on this basis, and strategist Jeff DeGraaf says real yields remain in the zone that should support lower nominal yields (meaning higher bond prices), although not by much. DeGraaf says triple-B-rated corporate debt seems to be where decent value still lies, especially with the current BBB-index yield of around 5.3% comparing favorably with the free-cash-flow yield on the S & P 500, making this tier of debt more attractive on a risk-reward basis than the equity index at the moment. From a broader view, too, the recent grab for yield among investors reflects a return towards more normal levels of debt ownership after years in which the public remained happily underexposed. The American Association of Individual Investors’ monthly asset allocation survey for December showed bonds at 14.3%, below the survey’s long-term average of 16%. Similarly, debt bottomed out in Bank of America wealth-management clients’ portfolios at 17% last year and is now up to 21% but still shy of the 18-year average of 26%. Even if rebuilding fixed-income holdings is a rational response to current conditions, it doesn’t mean continued great returns are promised. “While we expected that corporate bond portfolios would deliver strong total returns entering 2023, in large part due to enhanced yield support, the market downshift in rates in recent weeks has dramatically front-loaded this performance,” said credit strategists at Goldman Sachs. Given the firm’s expectation that a China reopening and better growth in Europe will support greater economic resilience, the strategists see an upside bias to yields even as credit spreads should remain contained. What happens in a recession? Bank of America’s credit group, meanwhile, is suggesting that high-yield corporate debt offers an insufficient margin of safety to account for the chance of economic slippage, with the junk-bond index spread not far above four percentage points (it was a full six percentage points on July 1). BofA was telling clients to “de-risk methodically” into the recent strength in junk-bond values. Elsewhere at BofA, global strategist Michael Hartnett agrees with the consensus that Treasuries will produce a positive return this year (they’re already up 3%) after two straight down years. He says Treasuries have never lost money three straight calendar years. Yet he offered what he calls the “biggest contrarian trade of ’23,” that the onset of a US recession could coincide with the low in bond yields, as markets react to fiscal authorities panicking to stimulate demand and longer-term inflation settles at a higher-than-hoped level. Not to mention the prospect that investors are now congratulating themselves for earning a comfortable yield while prudently shunning equity risk could face a steep opportunity cost if stocks manage to seize on potential soft-landing signals to redeem the unproven, minority view that a new bull market might have begun. Not all these scenarios can play out together, and one probably shouldn’t construct long-term portfolios based on assertively contrarian forecasts of several economic variables behaving a certain way. But taken together these outlooks are a reminder that even a well-reasoned — and, so far, well-rewarded — push into bonds to start the year is no guarantee of quick gratification. Bonds are meant to let you sleep at night, not help you party until the wee hours.
