Fund Spotlight: Bond Strategies for 2023

For years, bond and fixed-income investing were simplified by the Federal Reserve’s zero interest rate policy. Many bonds offered zero or near zero interest. Bank CDs weren’t much better. After a brutal 2022, many parts of the bond market reset the table. Bonds became a great way to achieve income investing goals again, with yields climbing past 4 percent on short- and long-term government bonds.

Most bonds pay fixed coupons, the same amount and usually twice a year. When interest rates rise, the price of an existing bond will fall because investors can buy new bonds with higher yields. When interest rates fall, the bonds go up in price because new bonds offer less income. Investors holding bonds to maturity don’t worry as much about changes in interest rates, but those investing in bond funds will see the fund value rise and fall in the opposite direction of interest rates.

There are two main risks with bonds: interest rate risk and credit risk. U.S. Treasurys have no risk of default because the government can print money to pay principal and interest. The price of Treasury bonds moves entirely based on the interest rates. If the market pushes rates up, Treasurys sell off. If the market pushes rates down, Treasurys rally. Corporate bonds also move based on interest rates, but their price change isn’t solely determined by changes in interest rates.

Investors can quickly access the interest rate risk of a bond by looking at the duration, a statistic found on nearly all financial websites. The rule of thumb is that for every 1 percent change in the relevant interest rate, the price of the bond or fund will move by the duration. If a fund has a duration of 5 and interest rates rise/fall one percentage point, the fund will decrease/increase about 5 percent.

Credit risk also factors into bonds of companies and countries that don’t issue debt in their own currency. The higher the credit risk, the more the price of the bond will be driven by credit risk rather than interest rate risk. In the past decade, the only way to obtain significant income from a bond portfolio was through higher-yielding bonds. For the first time since before the 2008 financial crisis, these bonds finally have some competition.

Conservative Short-Term Bonds

It has been more than a decade since investors could expect a nice return in a money market fund, but those times are back. Fidelity Government Money Market (SPAXX) has a 7-day SEC yield of 3.96 percent. Since the Federal Reserve isn’t done hiking, it’s almost guaranteed to rise to around 4.25 percent in the next month and then possibly toward 5 percent or more later this year if the Fed keeps hiking. This income is “risk free” since it comes from U.S. government securities.

Investors can achieve slightly higher yields with short-term bond funds such as Fidelity Short-Term Treasury Bond Index (FUMBX), which yields 4.10 percent.

The risk with these funds isn’t loss of principal; instead, it is the potential loss of income if bond yields fall. Investors will not receive much “compensation” via capital gains as yields fall.

These funds are best suited for two environments. First, when interest rates are stable, they can produce reliable income over long periods of time. Second, when interest rates are rising, they mitigate losses. In 2022, SPAXX gained 1.31 percent. Even though it has a low duration, the rapid rise in rates sank FUMBX by nearly 7 percent.

Investors who do not expect any rate cuts and want to capture rising rates with no risk can stick with a money market fund such as SPAXX. Investors who think rates might peak later this year and who might hold the position into 2024 when the possibility of rate cuts will increase, have more potential upside from FUMBX while collecting a similar level of income today.

Diversified Bond Funds

As long as interest rates are in a normal range, investors can profit from bond diversification. Exposure to Treasurys, corporate and high-yield bonds of varying maturities can produce good income and solid long-term returns. Diversified bond funds such as Fidelity Total Bond (FBND, FTBFX) currently yield 3.13 percent.

Total bond funds were down about 17 percent at their lows last year. Adjusted for dividends, these funds lost all their gains going back to 2015. It’s worth noting the bulk of the gains came in between 2019 and 2022 when the Federal Reserve was slashing interest rates to zero. If we remove dividends, the losses on the bond portfolios exceeded those of 2008. Stripped of dividends, the low for FTBFX in 2022 came within a few percentage points of the 2008 low.

One of the axioms of investing is “buy low, sell high.” While the process of making a low can be complex and take time, the price of commodities such as crude oil, wheat and natural gas all point to falling inflation later this year. The capital losses experienced by bonds in 2022 won’t be repeated this year or next. If the Federal Reserve stops raising rates later this year, the risk of capital losses will decline and be replaced by potential gains from falling rates.

Investors who want a little more income with less credit risk can opt for the far more narrowly invested Fidelity Intermediate Treasury Bond Index (FUAMX). It has a 30-day SEC yield of 3.57 percent and a duration of 6 years. The fund gained about 3 percent from October to February when the 10-year yield fell about one percentage point. This gives investors similar income without any of the credit risk contained in FTBFX.

Within the bond universe, broadly diversified funds will always deliver a return somewhere in the middle of the bond market. These funds are best for investors with very long holding periods who want to minimize the number of funds in their portfolio.

Long-Term Government Bonds Are an Aggressive Option

In prior years, investors referred to long-term government bonds as “return free risk.” Income was a pittance and did not compensate for the risk because bond yields couldn’t get much lower with the Federal Reserve at zero percent. Getting the lower bond yields seen in Japan and Europe would require the Federal Reserve to cut going into negative territory with interest rates. The risk in long-term bonds manifested itself in 2022. Long-term Treasury bond funds tracked the Nasdaq, with both asset classes losing more than 30 percent of their value.

With bond yields rising since then, long-term government bonds offer potential capital gains in the event of a recession and interest rate cuts. From the October low to the December high, the Fidelity Long-Term Treasury Bond Index (FNBGX) gained 16 percent. In February though, the fund gave back close to half those gains. This level of volatility is unsuitable for most investors. Additionally, the 3.75 percent yield offers no income advantage on money market and short-term bond funds but still contains substantial downside risk if inflation and interest rates do not peak this year or eventually go much higher.

That said, unlike in 2021 and 2022, long-term government bonds can potentially hedge a portfolio against recession and bear market risk if yields drop. If and when signs of recession appear, aggressive active investors may consider using long-term government bond funds as a hedge against that risk.

High-Yield Bonds Remain Attractive

High-yield bond funds are least attractive in a recession and most attractive in growing economies when credit risk is low. Talk of recession has picked up because the yield curve is inverted and inversions of this size have been followed by recessions in the past, but the timing of such a recession is unknown. At the moment, the Atlanta Federal Reserve’s GDPNow model has been hiking its growth forecast for the first quarter, hitting 2.8 percent as of February 27. The market has been reducing its assessment of credit risk since July. Spreads between higher-yield bonds and similar Treasurys have been falling since then.

Fidelity Floating Rate High Income (FFRHX) has a duration that approaches zero because the bonds in its portfolio reset as interest rates rise. FFRHX has a positive return since the end of 2021 because most of the bond market risk last year was centered on interest rate risk, not credit risk. It has an 8.55 percent 30-day yield, and that can go higher with Federal Reserve rate hikes.

Credit risk is the main worry for investors in this fund. The low in FFRHX came in July 2022 (the fund was down about 5 percent from its high at that point) because that is when credit risk peaked.

Floating-rate funds such as FFRHX only suffer if interest rates start falling, in which case the yield on these bonds will also.

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