From an investors’ viewpoint, 2022 was a year to forget. Fixed income investors suffered from a series of steep rate hikes by a Federal Reserve intent on taming inflation. Inflation itself soared. The economy began to exhibit signs of slowing and many investors pulled out of fixed income, further exacerbating poor performance. The Bloomberg US Aggregate Bond Index—a proxy for a diversified fixed income portfolio and one that many investors and institutions use—delivered a negative total return in 2022 of more than 12%, its worst annual performance since the 1970s. That’s not exactly the offset to equity performance that many investors were expecting from bonds.

We think 2022 was an outlier and expect fixed income will once again resume its traditional role in investment portfolios as a diversifier of returns, particularly if inflation moderates and the Fed decelerates its pace of rate hikes. Financial markets are unpredictable, and no one knows the future, but we think investors would be well-served by looking back at a terrible 2022 and applying resolutions towards a better 2023. 

Resolved: Consider Duration Exposure
Many bond investors, both individuals and institutional, invest passively in an index. A popular index is the Bloomberg US Aggregate Bond Index, commonly referred to simply as “the Agg.” From 1992 to 2010, the duration (which is a measure of interest rate sensitivity based largely on maturities) of the Agg generally was between four to five years. However, unbeknownst to many investors, in 2010 the duration began increasing and nearly reached seven years (6.8) by December 2021. 

Looking back, what did this mean for investors? Just as one of the most aggressive periods of rising rates was beginning in 2022, the interest rate risk of the Agg was substantially higher compared to historical averages. Thus, at exactly the wrong time in the interest rate cycle, many investors were taking on much more risk than they may have wanted. The results were devastating for performance.

Resolved: Consider the Type of Fixed Income
Fixed income is a broad category of investments. There are bonds, loans, floating rate notes, municipal debt, structured transactions, investment-grade, high-yield, and on and on. Which do you or your clients have?  Several?  Twenty?  This leads us to another possible resolution for 2023: think about the types of fixed income in your portfolio. Remember, an index like the Agg is composed of whatever gets issued into the market. That means, the more that is issued—and for whatever reason—the more goes into the Agg. Currently, Agency MBS, which are bonds backed by parcels of home loans, are a large component of the Agg. In fact, they accounted for approximately 28% of the total Agg as of late 2022. These bonds offer higher yields than corresponding Treasuries, but they carry added risks, such as prepayment and repayment risks. Agency MBS has historically been very sensitive to rising rates as they are linked to changes in mortgage rates. At the beginning of this rate hike cycle, investors may have preferred being underweight Agency MBS given the uncertainties associated with mortgage rates. At the same time, they may have preferred to being overweight another corner of fixed income. But a passive investment in a fund that tracks the Agg ties an investor to whatever is in the index at that time. 

Resolved to Do Better
Diversification is important when it comes to building an investment portfolio, and we believe an allocation to fixed income is still valuable. But investors should not settle for whatever duration and security mix are found in the most popular index. Investors should ask themselves instead if the use of that index best serves their needs, meets their risk tolerances, and positions them for what might be expected to be the best return in the year to come. A trusted financial advisor might be able to help. 

Some investors may be leery of bonds coming out of one of the worst markets in almost 50 years. This is understandable. But in our opinion, fixed income presents an attractive opportunity for reallocating new funds. Yields across all fixed income are substantially higher than just one year ago; many are at or near the highest we've seen in the last 10 years. This could make fixed income a compelling investment compared to other asset classes. Ultimately, we think it’s wise for fixed income investors to allocate with purpose and nuance, and thus consider the merits of an active approach that can most closely meet objectives and risk tolerances.