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Steve Lowe, CFA
Chief Investment Strategist
Kent White, CFA
Vice President, Head of Fixed Income Mutual Funds

Why rising bond rates in 2022 offered improved income opportunities for investors

By Steve Lowe, CFA, Chief Investment Strategist & Kent White, CFA, Vice President, Head of Fixed Income Mutual Funds | 12/19/2023

In 2022, the fixed income markets experienced one of the largest and swiftest increases in bond yields on record. Bonds, which historically provided stability and downside protection in a diversified portfolio during equity bear markets, did neither in 2022.  

During the first three quarters of 2022, Treasury bond yields across the maturity spectrum surged to over 4%, a level not seen for over 14 years, driving down total returns to a level only marginally better than the sharply negative returns of the stock market.

High-quality mortgage-backed securities, which were roiled by a doubling of interest rates in underlying new mortgages and uncertainties over the Federal Reserve’s (Fed) immense mortgage portfolio, saw yields increase to over 5%. Meanwhile, as the economy showed signs of moving into recession, credit spreads moved significantly wider as investors required more yield premium to compensate for increasing credit risk. This added risk premium pushed yields on investment-grade corporate bonds to over 6%. 

After years of paltry yields, the opportunity set in the fixed income markets offered significantly more value. Furthermore, this significant revaluation of the bond market with meaningful yield opportunities provided more of a buffer to a diversified portfolio during the equity bear market that ended in October 2022. 

What opportunities and risks came available in the various sectors of the fixed income markets after such a significant revaluation of this very large and important segment of the capital markets?

Cash and money market securities. Cash was no longer considered “trash.” After years of paying practically nothing, money market securities and funds provided yields that approximated 2.75 to 3% as of November 2022. Savers and investors were finally able to earn a reasonable return on what is considered to be a safer sector of their portfolio.

Short/intermediate maturity bonds. Yields in this sector of the market rose the most as the Fed raised rates and the yield curve inverted. Short-maturity Treasury securities, with yields of 4 to 4.4%, were pricing in an increase of at least another 125 basis points in short-term interest rates. Short duration corporate, mortgage and asset-backed securities provided yields of 5.5 to 6%.

Investment-grade corporate bonds. With both interest rates and credit spreads moving significantly higher in 2022, corporate bonds provided much more compelling yields. The Bloomberg Corporate Bond index had an average yield of approximately 6%. A deep and prolonged recession, with the potential for even wider credit spreads, would be a key risk factor for this sector, which did not happen in 2023, keeping corporate bonds attractive.

High yield bonds and leveraged loans. It was surprising that as of November 2022, the high yield market performed better than its investment-grade bond market counterpart, although returns were still sharply negative. The Bloomberg High Yield Bond Index and the JP Morgan Leveraged Loan Index averaged yields of 9.5 to 10.0%, which were pricing in higher default losses into 2023. The key risk with this market is the potential for a deep recession which would escalate defaults. In uncertain economic environments, investing in this high-risk sector of the market requires some patience.

Municipal bonds. It is difficult to make general comments about valuation in the municipal bond market given that it is such a heterogeneous market in terms of credit quality, security characteristics and varying state income tax rates. The average yield on investment grade municipal bonds was about 4% in November 2022, while higher risk, below-investment grade municipal bonds were paying an average yield of more than 6%. When adjusting these returns for taxes, the municipal market was compelling, but only for higher tax bracket investors. Like corporate bonds, the big risk with municipal bonds is credit quality. In addition to the risk of economic weakness pressuring municipal credit quality, contentious political circumstances has the potential to add another dimension to credit risk. 

Alternative fixed income. Like the high yield market, fixed income alternatives collectively provided a modest performance advantage over conventional fixed income sectors in 2022. Surprisingly, some high dividend paying sectors of the equity market, which can be considered fixed income surrogates, performed quite well. Utility stocks suffered only modest declines as of November 2022, while energy related dividend paying equities, such as Master Limited Partnerships (MLP), performed exceptionally well. Preferred stocks, however, performed poorly given their long duration and subordinated position in a company’s capital structure. Selective fixed income alternatives were attractive given their high income and diversification benefits. Specifically, opportunities in the preferred sector were compelling, as were specific opportunities in mortgage-backed securities, some MLPs and discounted closed end funds. Note, astute security selection is required given the very idiosyncratic nature of the alternative fixed income market.

After such a dramatic re-valuing of the fixed income market in the first nine months of 2022, real opportunities for income and diversification became present after years of yield drought. Some higher risk areas of the market were even considered attractive as equity surrogates for long-term returns. At much higher yield levels, Treasury securities and other high quality fixed income assets were valued such to resume their historical diversification benefits as a portfolio shock absorber if the bear market in equities had persisted. 

All information and representations herein are as of 12/19/2023, unless otherwise noted.

The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Thrivent Asset Management, LLC associates. Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.

Any indexes shown are unmanaged and do not reflect the typical costs of investing. Investors cannot invest directly in an index.

Past performance is not necessarily indicative of future results.

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