The Bond Market is Poised for Another Year of Dismal Returns

The year that was expected to mark a robust rebound for bonds appears to be falling short of expectations. Following a challenging 2022 for bonds, which saw historically poor performance, the widely monitored Bloomberg U.S. Aggregate bond index has incurred a 1.1% loss through Thursday, encompassing both price fluctuations and interest payments. This trajectory places it on course for its third consecutive year of negative returns.

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While losses are a natural facet of investing, bonds have traditionally been perceived as a secure option for investors, especially those nearing retirement. Prior to 2022, the Bloomberg index had never recorded negative returns for two consecutive years.

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Sonu Varghese, Global Macro Strategist at Carson Group, a financial advisory firm, remarked on the current bond market climate, stating, "Overall, 'it's gone from OK to terrible' for bonds this year."

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Investors usually anticipate returns in line with the yields on the bonds they acquire. At the outset of the year, optimism was high as last year's upheaval, spurred by the Federal Reserve's vigorous interest rate hikes to combat inflation, had pushed yields on investment-grade bonds above 4%. To attain their projected returns, investors simply needed bond prices to stabilize. This optimism stemmed from the widespread anticipation of an economic slowdown that would drive rates lower and bond prices higher.

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In the early part of the year, these forecasts seemed well-founded. Bonds rallied in March, fueled by concerns of an impending recession following the Silicon Valley Bank's collapse.

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However, since then, investor sentiment has undergone a significant shift. Worries about a recession have subsided, and expectations for future interest rates have risen. This shift is not so much due to the belief that the Fed will continue raising rates but rather because of the economy's surprising resilience, which has led investors to see less need for the central bank to lower rates in the coming years.

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Since June 30, the yield on the 10-year U.S. Treasury note has climbed from 3.818% to 4.572% as of Friday. The Bloomberg U.S. Aggregate index, primarily composed of Treasuries, government-backed mortgage securities, and corporate bonds, is projected to lose approximately 3% in this quarter.

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Anticipations of higher interest rates tend to drive down bond prices as investors become concerned that future bond issuances will offer larger coupon payments than existing ones. Consequently, yields, which represent the expected annualized returns under the assumption that bonds will be paid at face value upon maturity, rise.

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Putting money into actively managed bond funds has not been a surefire way to secure a positive return this year. Of the 85 actively managed core U.S. bond mutual funds that employ the Bloomberg U.S. Aggregate index as their benchmark and possess up-to-date data, only six have managed to generate a positive return, according to Morningstar Direct.

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Over the past 21 months, the 10-year Treasury yield has crossed various key thresholds, starting with 2% in early 2022, each time triggering debates about whether it can attain the next milestone. Now that it has exceeded 4.5%, the next benchmark is 5%, which some investors believe is readily attainable.

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Priya Misra, a fixed-income portfolio manager at J.P. Morgan Asset Management, noted the existence of two distinct macroeconomic camps. One camp anticipates that it will take time for higher interest rates to decelerate the economy, while the other believes that something fundamentally changed in the post-pandemic landscape. Misra aligns herself with the former group, anticipating a sharp decline in growth in the near future, making longer-term bonds an integral part of a diversified portfolio.

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Although further increases in the 10-year yield may be challenging, there is still ample room for it to decline if the economy experiences a slowdown, Misra added.

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