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Market Update

Where to Invest in Bonds in 2023

After investors suffered their worst losses ever in 2022, bond returns are poised to rebound next year.

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Investing in Bonds in 2023

  • Focus on the middle of the yield curve in the first half and look to lengthen into longer maturities in the second half.
  • Corporate bonds may encounter choppy waters in the near term, but we see calmer seas thereafter.
  • We expect the Federal Reserve is close to concluding tightening monetary policy and will begin to loosen in the second half of 2023.
  • The preponderance of interest-rate increases we expected in the longer end of the yield curve is behind us.
  • The stagnant economy in the first half of year could dip into recession; if so, we expect it would be short and shallow.

2022: Worst Fixed-Income Performance Ever

In our 2022 Market Outlook, we projected that there were four main headwinds the markets would need to contend with:

  • Slowing rate of economic growth,
  • Tightening monetary policy,
  • High inflation,
  • Rising interest rates.

As each of these headwinds has played out, bond markets have experienced their worst annual performance since the inception of Morningstar’s fixed-income indexes. In fact, looking at other indexes dating back to 1976, this year was the worst performance for fixed income ever. The Morningstar US Core Bond Index (our broadest proxy for the fixed-income market) fell 11.80% for the year to date through Dec. 12, 2022. No part of the fixed-income markets was spared, as rising interest rates across the entire bond yield curve pushed down bond prices.

Table of fixed income returns for Morningstar Fixed Income Indexes

No part of the bond yield curve was spared from rising interest rates. In the short end of the curve, the interest rate on the one-year U.S. Treasury bond rose 436 basis points to 4.75%. In the middle of the curve, the yield on the five-year Treasury rose 254 basis points to 3.80%. In the longer end, the 10-year Treasury yield rose 209 basis points to 3.61%.

Graph of current Treasury Yield Curve as compared to end of 2021

Although defaults have yet to meaningfully increase, corporate credit spreads widened out as investors began to price in higher future default expectations. In the investment-grade market, the credit spread of the Morningstar US Corporate Bond Index widened 32 basis points to +127. In the high-yield market, the Morningstar US High Yield Bond Index widened 134 basis points to +437.

With its longer duration (a measure of interest-rate sensitivity), the Morningstar US Corporate Bond Index underperformed the broader fixed-income market selloff and declined 14.10% for the year to date. With its shorter duration and higher yield carry, the Morningstar US High Yield Bond Index lost less, dropping 9.67%.

Average credit spread of the investment grade and high yield corporate bond indexes over past 3 years

Outlook for Investing in Bonds in 2023

As we head into 2023, we expect that the Fed is nearing the end of its tightening cycle and that the preponderance of interest-rate increases in the long end of the curve are behind us.

Looking forward, from an economic point of view, we expect that the U.S. economy will be stagnant in the first half of the year and that there is up to a 50% chance the economy will enter a recession. However, we expect that a recession would be short and shallow and that economic growth would reaccelerate in the second half of the year. Overall, for 2023, our U.S. economics team is projecting that real U.S. gross domestic product will be only 0.7% but the positive momentum in the second half of the year will carry into 2024, where we forecast GDP will increase by 2.5%. We also forecast that inflation will remain on a downward trend throughout 2023; our forecast for average inflation is 2.9%.

In our view, the combination of a weak economy and declining inflation will provide the Fed room to begin easing monetary policy. Initially, we expect the Fed will end its quantitative tightening policy of letting maturing bonds roll off its balance sheet. Then in the second half of the year, it will begin to cut the federal-funds rate.

Interest-Rate Expectations

During 2022, the Fed conducted the fastest interest-rate-hiking cycle since the early 1980s when inflation was in the double digits. At this point, we expect the Fed is close to a point when it will halt additional rate hikes. We forecast that the federal-funds rate will average 4.33% over the course of 2023.

In the longer end of the yield curve, we forecast that the yield on the 10-year U.S. Treasury bond will average 3.50% in 2023. Over the next few months, we could see the yield increase slightly based on the impacts of ongoing quantitative tightening and high inflation, but our forecast is that the interest rate on 10-year Treasuries will end the year below its current level. For the first half of 2023, the middle of the yield curve (three- to five-year maturities) appears to provide the greatest amount of yield for the least amount of duration risk.

Looking a little further into the future, in the second half of 2023, based on our forecasts, investors may look to lengthen their duration into longer-dated bonds. Based on our expectations that the Fed will be cutting the federal-funds rate in the second half of 2023, our forecast for the rate averages 2.50% in 2024. The combination of a lower federal-funds rate and declining inflation will also lead to a lower yield on the 10-year Treasury, which we forecast will average 2.50% in 2024.

Morningstar's forecasts for federal funds rate and 10-year U.S. Treasury bond for next 5 years,

Corporate Bond Market Outlook

Over the next few months, the corporate bond market may encounter some choppy waters, but we expect seas to be calmer thereafter. For investors that can ride out a potential short-term squall, we find value in the credit spread and high all-in yields that corporate bonds, especially high-yield bonds, provides.

Corporate credit spreads may be under pressure in the first half of 2023 as economic metrics point to a stagnant economy. In our view, this pressure should be short-lived. While bankruptcies may increase, considering we expect a potential recession to be short and shallow, the default rate should not spike meaningfully higher. Over the past year, most companies have extended their debt maturities, so refinancing maturing debt will not be a significant problem. In addition, so long as the recession is relatively short, most firms should have enough liquidity to weather a mild recession.

The combination of higher interest rates and wider credit spreads has significantly boosted the yield for both investment-grade and high-yield bonds. After hitting all-time lows in 2021, interest rates on corporate bonds have risen well above their 10-year averages. The yield on the Morningstar US Corporate Bond Index is 5.16%, and the yield of the Morningstar High-Yield Bond Index is 8.27%.

How Do Current Corporate Credit Spreads Compare With Historical Averages?

In bond vernacular, corporate credit spreads are “tight” when low spreads provide only limited compensation for credit risk. Over the past 20 years, corporate credit spreads have been lower than current levels about 30% of the time. Based on how much spreads have widened over the past year, it appears the corporate-bond market is already pricing in a mild recession and a slightly higher default rate. In our view, corporate bonds are poised to perform much better in 2023 as credit spreads already incorporate a weak economy and long-term interest rates are expected to begin declining in the second half of the year.

Chart that depicts the credit spread of the Morningstar Corporate Bond Index since 2000

Chart of the credit spread of the Morningstar High Yield Bond Index since 2000