Posted by Lawrence Gillum, CFA, Fixed Income Strategist
Tuesday, February 28, 2023
Bond investors experienced the worst year ever for core bonds last year (as per the Bloomberg Aggregate Bond Index), -so the prospects of another year like 2022 could be hard to fathom. The good news is we don’t think we’ll see another year like 2022 anytime soon, but despite the higher starting yield levels, we could see periods of negative returns. In fact, after a strong January for core bonds, unless yields fall dramatically today, February returns will be negative. But that is normal. Since inception of the index in 1975, over a third of the monthly returns have been negative and close to 25% of quarterly returns have been negative. Bonds trade daily and interest rates change throughout the day as well, so that means the market value of a bond will change daily as well.
However, fixed income instruments are fundamentally different than other financial instruments. Bonds are financial obligations that are contractually obligated to pay periodic coupons and return principal at or near par at the maturity of the bond. That is, there is a certainty with bonds you don’t get from many other financial instruments—and that is starting yields (yield-to-worst more specifically, which is the minimum expected yield that can be received from a bond absent an issuer defaulting on its debt). Starting yields take into consideration the underlying price of the bond as well as the required coupon payments, therefore, starting yields are the best predictor of future returns. Starting yields and subsequent returns for the Bloomberg Aggregate Bond Index have a very tight relationship. For holding periods as short as five years or as long as ten years, starting yields explain approximately 94% to 95% of returns for the index. That relationship breaks down over shorter periods though with only approximately 40% of 1-year returns explained by starting yields—there is much more variability (noise) over shorter horizons. But if you buy and hold a fixed income investment, the short-term volatility you experience due to changing interest rate expectations is just volatility. It has very little bearing on the actual total return if held to maturity (or if held to the average maturity of a portfolio of bonds).
After the historically awful year for fixed income investors last year, it may be disheartening to see another month (or more) of negative returns. We would advocate for a longer-term perspective though. Current yields within many fixed income markets are at generationally high levels. Investors can take advantage of these high starting yields but only if they stay invested and look past the (normal) short-term volatility that happens on occasion.
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