Bonds take center stage at midyear 2023

Key takeaways

• The Fed is still fighting sticky inflation, so interest rates—and bond yields—are likely to remain high.
• After a decade of minimal returns, bonds are attractive again. While cash positions were an effective diversifier last year, keeping clients in cash for too long could cause them to miss out on locking in higher yields for the longer term.
• 2022 was highly unusual. Bonds lost 10% in the first four months of the year, which is one of the worst returns in U.S. history.1 Over the long term, bonds are still a great diversifier of equity volatility.

Take advantage of higher bond yields

Opportunities in the fixed income market abound in the second half of 2023 as sticky inflation continues to drive higher bond yields. Vanguard Chief Economist Joe Davis predicts that we will continue to see modest progress on the inflation front, in part because central banks will need to keep interest rates in restrictive territory to bring inflation down to their preferred 2% target. We’ll see some economic weakness in the second half of 2023 along with those higher interest rates.

“The one silver lining in all this is that you have parts of the financial markets, in particular the bond market, increasingly pricing in this reality of higher interest rates,” Davis said, “not only for this year but for the years to come.”

Because we are most likely near the end of the Fed’s rate hiking cycle, we believe now is the time to add high-quality fixed income exposure. If a recession does arrive in the next quarter or two, we expect investment-grade bonds to hold up reasonably well and benefit from price appreciation once the Fed is able to cut rates.

Don’t get distracted by short-term thinking

Given the attractive yields money market funds offer now, you might be tempted to keep your clients in cash and wait for the “right” moment to get them back into the market, especially since fixed income markets and interest rates have continued to experience volatility in 2023. However, predicting the path of interest rates is notoriously hard to do. And in today’s environment, there’s less room for error now that yields have increased so much.

Bonds still an effective diversifier

Clients may still be experiencing strong emotions about last year’s market performance, but it may help to remind them that 2022 was a highly unusual year; bonds lost 10% in the first four months of 2022, which is among the worst returns in U.S. history.¹ But, the anomaly that was 2022 sets us up for better returns looking forward. According to Vanguard Global Head of Fixed Income Sara Devereux:

• Valuations are materially better than they’ve been. “We haven’t seen yields like this in a decade,” said Devereux.
• Income is back in fixed income. The coupon component of bond returns is very stable, offering a real buffer to price volatility.
• Diversification benefits are back. Last year was highly unusual, but in 2023, bonds are behaving more normally. Over the long term, bonds are a great diversifier of equity stress.
• If the recession we are forecasting arrives before the end of this year, it pays to remember that bonds tend to outperform in a recession.

Sample the strength of our fixed income funds

Take advantage of this opportunity to leverage bonds and potentially improve investment returns for your clients.

¹ Jason Zweig. It’s the Worst Bond Market Since 1842. That’s the Good News. Accessed July 19, 2023 at https://www.wsj.com/articles/its-the-worst-bond-market-since-1842-thats-the-good-news-11651849380.

Notes

• For more information about Vanguard funds or Vanguard ETFs, visit advisors.vanguard.com or call 800-997-2798 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.
• Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.
• All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
• Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments.