Fixed Income 2023: Here Are the Opportunities

J.P. Morgan Asset Management has upgraded its credit outlook to overweight, reflecting expectations of declining rate volatility in the coming months. In this environment, the investment bank expects “better carry opportunities to emerge across U.S. investment-grade (IG) credit, parts of the European credit complex and even in some segments of emerging market debt (EMD).” The analysts favor U.S. Treasuries over core European bonds.

It’s no surprise that U.S. Treasuries are being viewed more favorably in light of the Federal Reserve’s campaign of historic rate hikes in 2022. Yields on the short end of the curve offer a highly compelling risk-reward profile relative to stocks, according to Ken Stern of Lido Advisors. The two-year U.S. Treasury yield peaked above 4.7% in November and is likely to end the year well above 4%, giving us the most favorable rate environment since 1987, according to Stern.

Investors expect some variation of a soft pivot from the Federal Reserve in 2023 as growth conditions continue to weaken. J.P. Morgan sees a mild contraction as “increasingly likely in 2023” but has not ruled out the possibility of a “deeper recession.” A recessionary scenario could potentially lead the Fed to cut rates again in the second half of 2023, offering bondholders the ability to lock in capital gains on their Treasury positions as rates fall. If the Fed does shift course, longer-duration Treasuries could be in a position to outperform in the latter half of 2023.

Overall, Vanguard forecasts that U.S. bonds will see net positive returns in the range of 4.1% to 5.1% per year over the next decade, which is considerably higher from even one year ago.

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It may be too premature to talk about what the Fed could do six months from now. In the here and now, policymakers remain committed to raising interest rates, possibly past their so-called “neutral rate,” in order to tame inflation. (For reference, after the December meeting the Federal Open Market Committee has penciled in 5.25% as the upper end of its federal funds rate in 2023. However, seven Fed officials see rates topping out between 5.5% and 5.75%.)

Just as this environment bodes well for longer-duration Treasuries, investment-grade corporate bonds are also likely to benefit, according to Marc Pfeffer, a managing director with S64 Capital Innovation. This is further reinforced by credit markets pricing in relatively healthy corporate fundamentals heading into 2023. According to VanEck, “corporate balance sheets are healthier than they were before Covid, with leverage or interest coverage ratios actually as healthy as they’ve been in the last decade.” Of course, this is generally limited to the higher end of the credit quality spectrum, with analysts giving favorable outlooks for BB and B and higher ratings. In terms of corporate debt, analysts are generally favorable to industries such as energy and industrials.

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2023 is shaping up to be a difficult year for the global economy, and this will exacerbate central banks’ challenge of balancing growth with price stability. However, investors can position their fixed income portfolios to provide low-risk opportunities in a much more favorable yield environment.

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