Fixed Income: Q4 2022

Written by Brian S. Stivers

It was an unprecedented year for bond markets as the Federal Reserve raised interest rates +4.25% during 2022-underscored by four consecutive +0.75% hikes between June and November. That response and the very high level of inflation rates were both not seen since the early 1980’s. Entering 2022, the Fed and market participants did not foresee anywhere near this magnitude of hikes necessary to combat the once described “transitory” inflation by the Fed. Year-on-year Consumer Prices peaked at +9.1% in June and have declined to +7.1% through November.      
 
The Fed’s interest-rate projections for the Funds rate continue to rise. In December, the so-called dot plot now shows most FOMC participants expect interest rates to peak between 5.0% and 5.75% in 2023, up from under 5% in their September responses. By 2024, their median forecast declines to 4.125% or 4.25% for the upper bound tied to Prime rates currently at 7.5%. Their expected longer-run Fund’s rate of 2.5% remains the same. 

As expected during a tightening cycle, the Treasury yield curve declined throughout the year. For example, the 10-year less 2-year yields declined from roughly +0.8% to -0.8% during December. A transition from a normally positive sloping yield curve (higher long vs. short rates) to an inverted curve is seen as a recessionary indicator. The rates inversion in 2022 was first experienced in early April briefly, inverting again in early July and stayed negative throughout the second half.    

Speaking of recessions that debate started during the summer after two negative GDP readings -1.6% in the 1st quarter and -0.6% for the 2nd quarter (revised).  GDP is reported in “real” terms so nominal GDP given high inflation was still very robust. Real GDP for 3Q rebounded nicely to +3.2% and Atlanta Fed’s GDP Forecast for 4Q is currently +3.8%. With unemployment rates back down to recent/pre-pandemic lows of 3.5% and wage growth not seen in years, we have not yet experienced a recession. 

Given the rapid increase in rates during 2022, the Bloomberg US Aggregate Index produced a record loss of -16.8% through October 24. This date corresponds to the highest 10-year Treasury yield of 4.24% during 2022. Finishing the year at 3.88% yield on the 10-year, the Aggregate Index improved but still lost an unprecedented -13.01% last year. Because yields were so much higher in the 1980, this index only experienced a loss of around -9% and actually finished the year up +2.7%. During 2022, Treasuries lost a similar -12.5% and investment-grade corporates lost -15.8% given their longer duration.  
    
Investment-grade tax-free bonds started the year very weak, basically tracking the Aggregate Index very closely through May. Through May 18, municipals had lost -10.6% vs. -9.7% for the Aggregate. Because tax-exempt yields do not normally need to move 1-to-1 vs. Treasuries yields, we found this to be a reasonably good buying opportunity. At its worst on October 26, the Bloomberg Municipal Index was down -13.0% vs. -15.6% for the Aggregate Index. In November, tax-frees notched their strongest month of gains since 1986. In all, municipals returned -8.5% vs. -13% for the Aggregate Index. For our clients in laddered portfolios, Bloomberg’s 1-5 year and 1-12 year Muni benchmarks are more comparable finishing the year -3.2% and -4.8% respectively. Specializing in KY specific issuers, we think it’s worth mentioning that the S&P Municipal Bond Kentucky Total Return Index returned -7.5%., or +1% better than the national index in 2022.    

There is a bright-side to the significantly higher interest rates. Income generation from bond and bond funds should continue to grow for the time being. We expect that investment-grade fixed income should generate annualized returns of 3%-4% over the next 3-5 years. During periods of very low yields, we had always cited expected returns of 1-3% but with a footnote: “with a bias towards lower returns if interest-rates approach more historical levels, as the Fed attempts to normalize rates over the next several years”. Interestingly, the 5-year return for the Bloomberg Aggregate Index is basically flat or +0.02% annualized through December 2022, despite this year’s -13.0% decline. In comparison, investment-grade corporates and municipals returned +0.45% and +1.25% annualized, respectively over the last 5-years.

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