Bonds are rebounding in 2023 following one of their worst years ever as the asset class reclaims its function as an effective hedge for stocks. Case in point: Investors sought safety in Treasurys during the recent bank crisis. That wasn't the story last year, when rising interest rates hit the value of Treasurys and was the culprit of a stock bear market. The dual decline shook faith in the 60/40 portfolio, a strategy that refers to holding 60% in equity and the other 40% in bonds that has long been considered a bedrock of prudent investing. It challenged the long-held belief that diversification across assets bolsters returns, on the assumption that stocks and bonds move often inversely to one another, and led some in the investing world to declare the strategy was "dead." "Bonds are acting like bonds again," said Gina Bolvin, president of Bolvin Wealth Management Group. "Despite still elevated inflation levels and the Fed still hiking rates, high quality bonds are rallying and are providing that ballast to equity risks during this equity market drawdown. After the bad year last year, it's good to see bonds reassume their role as diversifiers in a diversified asset allocation." TLT 1Y mountain iShares 20+ Year Treasury Bond The iShares 20+ Year Treasury Bond ETF (TLT) highlights that rebound, with the fund up 7.3% in 2023 after dropping 32.8% last year. And the BlackRock 60/40 Target Allocation Fund Institutional Shares (BIGPX) , an ETF tracking returns on a 60/40 portfolio, is up 3.4% so far in 2023 following a 17.9% drop last year. Those gains come as both asset classes chart a comeback. The S & P 500 has gained 3.4% so far this year, making up ground after falling 19.4% in 2022, which was its biggest annual loss since the Great Recession. The Morningstar U.S. Core Bond Index added 3.4% this year after sliding nearly 13% — its worst year on record — in 2022. Following the down move last week, U.S. 2-year and 10-year Treasury yields are still near their highest levels in more than a decade. "It looks like the cycle high for yields is probably in, but there's still value and yield in bonds that investors have rarely seen since the financial crisis," said Ross Mayfield, investment strategy analyst at Baird. 'An opportune time' Money-market funds have seen strong flows in recent weeks as investors have fled to corners of the fixed income market deemed the highest quality in the wake of the bank closures. Money market funds hold short-term liquid securities such as Treasury bills. "For investors who might have shied away from bonds because of their performance in 2022 or because of the years of low yields before that, it may be an opportune time to consider adding bonds to portfolios," said Sara Devereux, global head of fixed income at Vanguard. What's more, because bonds tend to rally during a recession as benchmark rates decline, Devereux said she recommends focusing on high-quality fixed income including U.S. Treasurys, agency mortgage-backed securities and municipal bonds. Corporate bonds have yield-pickup opportunity, but investors need to scan for credit risk alongside a potential recession. Investors can further look to diversify their credit quality on the bond side of a 60/40 portfolio, said Chris Fasciano, portfolio manager at Commonwealth Financial Network, emphasizing quality fixed income that can help reduce price volatility at the same time as they lock in attractive income. Bond yields remain appealing as the first quarter of 2023 comes to an end, according to Sam Millette, Commonwealth's fixed income strategist. He noted that the 10-year U.S. Treasury's 3.9% yield is roughly double the trailing, 12-month dividend yield of 1.73% on the S & P 500. US10Y US2Y ALL mountain The U.S. 2-year and 10-year Treasurys He also recommended focusing on higher-quality bonds, adding that current high yields mean investors no longer have to over-allocate in lower-quality credit, which have higher default risk. Looking ahead, Millette said fixed income investors could see more upside through the end of 2023. "The combination of still high yields and the potential for price appreciation in times of market uncertainty make for a relatively compelling case for fixed income throughout the rest of 2023," he said. Bolvin said starting yields can help predict future returns on an investment, and current performance shows "the runway for solid returns within fixed income is just getting started." She said the outlook for high-quality bonds after last year's performance is the best she's seen in a decade. To add or not to add? The bullishness on bonds begs the question: Should investors add more exposure? Commonwealth Financial has not changed its allocations since the start of the year. But Bolvin pulled back on her stock overweight within her tactical model, citing improving return prospects for bonds. She reallocated 2% to bonds, bringing equity exposure down to 63%. Within fixed income, she also recommended investors stick to bonds with AAA or AA ratings, saying investors should look for risk in equities rather than lower-rated bonds. Bolvin has also upgraded preferred stock as they've been dumped during the banking crisis. Bolvin said she would consider between 2% and 5% allocation in preferred stock in a typical balanced portfolio. She also said investors who are skeptical interest rates will be cut soon, or very much, should add to quality bond holdings when the market dips. Bolvin, who predicted earlier this year that the 60/40 portfolio would be resurrected , said diversified portfolios have done a better job of helping investors mitigate volatility in 2023 — in part thanks to bonds. "While returns for stocks and bonds have been positive so far this year, that stocks and bonds are largely performing well at different times has made the ride smoother for investors," Bolvin said. "That is the point of a 60/40 portfolio. After all the calls for the death of the 60/40 last year, we think the prospects of a diversified portfolio are the best they've been in years because of the improved return prospects for fixed income."
