Morningstar - Q2 2023 - 32

Spotlight: Bonds
Is It Time to Pick Up the Pieces?
After a grueling year, the bond market
storm shows signs of abating.
Eric Jacobson
GRUELING
There have already been more ups and downs in
the bond market since last year's selloff, and there
may well be more ahead, but higher yields and
discounted bond prices could offer investors some
comfort. Although a lot has gone wrong, here's
what could-eventually-go right.
The Storm: Not a Question of If, but When
It's tempting to say that the bond market's 2022
debacle was a perfect storm. Far from holding
up in a rough year for stocks, bonds posted
double-digit losses across the spectrum-from
government bonds to junk debt ( EXHIBIT 1 ).
All told, the Morningstar US Core Bond Index
fell 13%.
Yet, that would imply an event that was shocking
and nearly unimaginable. Granted, predicting
the confluence of a global supply chain COVID-19
hangover with Russia's invasion of Ukraine
would have been hard. But a stagflation-driven
recession scare and a broad bond market
rout across interest-rate and credit markets was
always a realistic possibility.
With long-term bond yields held down by a
combination of plodding inflation and the Federal
Reserve sopping up the market's supply of
bonds through quantitative easing, it wasn't just
that 10-year Treasury yields fell to 1.5% at the
end of 2021 or that they had been held under
3% for almost the entirety of the prior 10 years. It
was that yield premiums for riskier debt (over
government bonds) had also been historically tight
over the past 10 years ( EXHIBIT 2 ). This
combination was fertile for a selloff.
32
Morningstar Q2 2023
25%
Before 2022, conventional bear-market
scenarios focused on rising rates in response to
inflation and a hot economy, similar to 1995,
when the Fed hiked and Treasuries spiked as the
economy grew. Corporate financials, in this
line of thinking, would stay healthy and corporate
debt valuations would remain comparatively
tight-and provide some ballast during the
Treasury market selloff.
The problem with predicting a 2022-style mess
would have been timing. Ever since the 2008
financial crisis, pundits had been arguing that
Treasuries were in a bubble. And with globalization
marching forward, along with what resembled
peaking oil prices and energy independence, the
inflation needle barely moved as a result of
economic growth, stagnation, or anything else.
Still, with rates so low and spreads so tight,
there was a nagging feeling that a rout could
come along at any time but no idea what might
trigger it. The relative success of a Fed-led
response to the 2020 COVID-19 crash even gave
some reassurance that the central bank
could cope with just about anything. The time
it took for the rout to finally arrive made
years of vigilance exhausting, costly, and
seemingly Pollyannish.
It was a strike at the foundations of the
post-World War II global order-Russia's invasion
of Ukraine-that generated both inflation
and recession fears and set off the fixed-income
storm of the century.
Partly Sunny or Partly Cloudy?
Many investors seem to think the tempest isn't
over. Taxable-bond mutual funds and
exchange-traded funds saw $216 billion in net
outflows last year, making 2022 the worst year for
flows since Morningstar began calculating the
data three decades ago, and more than 4 times
worse than any prior calendar year ( EXHIBIT 3 ).
The taxable-bond sector brought in more than
$1.8 trillion from 2017 through 2021 alone, at a
time when U.S. equity mutual funds and ETFs lost
assets, even including strong 2021 inflows.
After 2022, investors could be forgiven for
shunning bonds. But that could be a mistake.
What Happens When the Rain Stops?
It's not that bonds and stocks are entirely different
as investments. Stocks' potential for volatility
is multiple times that of bonds, but we generally
expect them to rebound, at least close to historical
average valuations (as long as the economy
grows). Still, a stock could hit zero.
EXHIBIT 1
Bond Markets Suffered Across the Board Fixed-income investors had no place
to hide in 2022.
Morningstar US Core Bond
Morningstar US Mortgage-Backed Securities
Morningstar US Treasury Bond
Morningstar US Corporate Bond
Morningstar US High-Yield Bond
Source: Morningstar Indexes. Data as of Dec. 31, 2022.
-20%
2022 Return
-12.99
-11.94
-12.43
-15.71
-15
-11.09
-10
-5
Morningstar - Q2 2023

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