Bond markets had a difficult year in 2022 as the Fed aggressively hiked interest rates to stamp out inflation. With the end of rate increases in sight, investors may be wondering if volatility may be replaced with relative tranquility in the year ahead.

At its December meeting, the U.S. Federal Reserve moderated its approach and lifted rates by half a percentage point to a range of 4.25% to 4.50%. Investors welcomed the downshift after an unprecedented string of four 0.75 basis point adjustments by policymakers attempting to quash decades-high inflation. But officials underscored that they will continue to raise rates to around 5% next year.

Wide-ranging challenges still lie ahead. Among them: Inflation remains stubbornly high, and economic activity is expected to slow or contract.

Here, fixed income portfolio managers from across Capital Group weigh in about what’s next for bonds.

Inflation has likely peaked, but should remain high

Even the most optimistic investors are bracing for a recession. The question is more a matter of how wide or deep the downturn will be as central banks worldwide raise rates to try to contain inflation. With growth expected to stall or contract in major economies including the United Kingdom, European Union, Japan and the United States, will high prices stick around in 2023?

Demand for sectors that quickly absorb rate increases, such as housing, has predictably declined. Other areas of the economy will take more time to cool.

“The impact of rate hikes will unfold over the next several months, likely in the form of higher unemployment, fewer job openings and declining retail sales,” says Ritchie Tuazon, portfolio manager for American Funds Strategic Bond Fund^SM.

So far, the economy has coped surprisingly well. Ironically, bright spots could feed into the inflation problem.

“Supply chain issues appear to have worked themselves out, but the labor shortage and persistent wage growth could keep inflation higher than the Fed’s 2% target range for some time,” Tuazon says. Geopolitical risks could further undermine the Fed’s efforts.

Bond funds should once again offer relative stability

Fixed income's role as a portfolio ballast when stocks are falling was of no help as the Fed continuously revised rate expectations upward.

It’s rare for both stocks and bonds to fall in tandem in a calendar year. In fact, 2022 marks the only time it occurred in 45 years. That’s because the Fed hiked aggressively when rates were near zero.

That should change in 2023 as inflation moderates. “Once the Fed pivots from its ultra-hawkish monetary policy stance, high-quality bonds should again offer relative stability and greater income,” according to Pramod Atluri, portfolio manager for The Bond Fund of America®.

As additional cracks start to show in the economy, recession fears may take center stage. “One way or another, the consumer is going to feel more stressed in 2023. Either the economy is so strong it continues to feed into inflation, or the economy weakens and unemployment rises,” Atluri says.

Historically, investing prior to the final rate hike in a cycle would have paid off. In the last 40 years, there were six hiking cycles that offer five years of returns data. Purchasing bonds regularly for a year starting six months prior to the last Fed rate hike in each of those cycles would have returned a range of 3.3% to 10.2% in the first 12 months. Longer term, that year-long investment would have provided a five-year annualized total return that spanned from 5.9% to 15.6%.

Income is back in fixed income

Bond market losses can be painful to endure, as rising rates cause bond prices to decline. The upside is that bond yields also rise, which may set the stage for higher income down the road.

The yield on the benchmark 10-year U.S. Treasury hovered around 3.47% on December 14, 2022, versus a yield of 1.51% on December 31, 2021. Yields, which rise when bond prices fall, have soared across sectors. Over time, income should increase since the total return of a bond fund consists of price changes and interest paid, and the interest component is higher.

With investors better compensated for holding relatively stable bonds, the question of whether to invest in riskier corporate or high-yield bonds ahead of a potential recession is an important one.

Despite gloomy headlines, consumers continue to open their wallets. “This has helped keep corporate balance sheets in pretty good shape,” says Damien McCann, fixed income portfolio manager for American Funds Multi-Sector Income Fund^SM.

The reward potential for corporate investment-grade bonds (BBB/Baa and higher) at current levels is enticing, but many are vulnerable in a downturn. “I expect credit quality to weaken as the economy slows. In that environment, I prefer defensive sectors such as health care over homebuilders and retail,” McCann says.

High-yield bonds are also relatively well positioned for an economic slowdown, and their prices have declined sharply. An uptick in defaults, which the market has already priced in, could still increase in a deep recession.

Municipal bonds are well positioned ahead of a downturn

The Fed-induced selloff sent municipal bond yields to near 15-year highs. For patient, long-term investors, that can make munis particularly attractive.

Historically, the allure of munis was their federal and often state tax-exempt status. Because of that, they generally have yielded less than comparable taxable bonds. Decades of low rates translated into modest income payments.

According to fixed income portfolio manager Karl Zeile, “Muni yields are reaching levels where the tax-exempt income is attractive.” The Bloomberg Municipal Bond Index was down 8.8% in 2022 (through November 30) and yielded 3.6%, which is the equivalent of a 6.0% yield for investors in the highest tax bracket. The highest tax rate assumes the 3.8% Medicare tax and the top federal marginal tax rate for 2022 of 37%.

“Thanks to robust employment and significant aid through the American Rescue Plan, state balance sheets are broadly in good shape,” Zeile reports.

Revenues have increased for some project-specific bonds such as toll roads, colleges and universities since they were able to pass higher costs to consumers. These so-called revenue bond issuers tend to issue long-term debt, so many have low fixed debt payments.

Lower tax revenue and other negative recessionary impacts take longer to flow to munis compared to corporate credit and high-yield bonds.

With many opportunities in higher rated issuers, “valuations don’t yet reward the risk of going meaningfully down in credit quality,” Zeile adds.

Why bonds are back

After a difficult year for bonds, there are reasons for optimism. Inflation has moderated, and Fed rate hikes are likely to peak in the not-too-distant future. Higher yields and the specter of a recession could also send investors back into bonds in search of relative stability and income.

Today’s starting yields can offer an attractive entry point for investors and provide a cushion to further volatility. There are also compelling opportunities across asset classes that an active manager can uncover via bottom-up research and security selection.