What is the outlook for bond funds in 2023? (2024)

What is the outlook for bond funds in 2023?

We expect generally good performance during the second half of the year, although volatility may increase, especially for high-yield bonds. Corporate bond investments generally performed well during the first half of the year.

Bond funds staged a fourth-quarter comeback in 2023. Through late October, the Morningstar US Core Bond Index, a proxy for the broad fixed-income market, was on pace for a third-consecutive year of losses as uncertainty around a hard or soft landing lingered and interest-rate volatility persisted.

We expect bond yields to decline in line with falling inflation and slower economic growth, but uncertainty about the Federal Reserve's policy moves will likely be a source of volatility. Nonetheless, we are optimistic that fixed income will deliver positive returns in 2024.

We think bonds will prove their worth again as a source of income and a diversifier to equities. There should be more opportunities ahead, even if investors need to traverse some moguls in the economy.

If you own shares of a bond ETF, you might have a sinking feeling seeing the market value of your investment dip as interest rates increase. However, it's worth noting that rising interest rates can't last forever, and bond ETF prices are likely to recover once rates go lower.

The fixed rate rose to 0.4% in November 2022 so any I bond purchased after that date should be held. Likewise, you may want to hold on to I bonds issued between May and October 2023. Those I bonds have a fixed rate of 0.9%, which is the highest fixed rate in 16 years.

In line with the outlook from other investment providers, the firm is forecasting a 5.7% gain in 2024 for U.S. investment-grade bonds, versus 4.9% last year and 2.3% in 2022. (All figures are nominal.)

Unless you are set on holding your bonds until maturity despite the upcoming availability of more lucrative options, a looming interest rate hike should be a clear sell signal.

Why interest rates affect bonds. Bond prices have an inverse relationship with interest rates. This means that when interest rates go up, bond prices go down and when interest rates go down, bond prices go up.

Top four schemes in the category offered over 7%. ICICI Prudential Corporate Bond Fund, the topper in the category, offered 7.60% in 2023. Aditya Birla Sun Life Corporate Bond Fund offered 7.29%. HDFC Corporate Bond Fund gave 7.20%.

Are bond funds a good investment right now?

If you are looking for reliable income, now can be a good time to consider investment-grade bonds. If are you looking to diversify your portfolio, consider a medium-term investment-grade bond fund which could benefit if and when the Fed pivots from raising interest rates.

Unless there is a change in your circ*mstances, we believe investors should continue to hold onto their bonds for the following reasons: The bonds will mature at par value, meaning you will receive the face value of the bond at maturity, so present-day dips in value are only temporary.

“Yields are fairly high now, and high-quality bonds that you hold to maturity are safe investments,” he said. Mr. Pozen added that well-diversified investment-grade bond funds make sense now, too, for prudent investors who are prepared to hold them for at least three years.

"Higher for longer" raises the term premium

The culprit for the market's poor performance is the term premium—the extra yield that investors demand to tie up their money in longer-term bonds versus holding short-term bonds and reinvesting them.

The table on the right shows that bond prices often recover within 8 to 12 months. Unnerved investors that are selling their bond funds risk missing out when bond returns recover. It is important to acknowledge that some of those strong recoveries were helped by bond yields that were higher than they are today.

The downside to owning bond funds is: The management fee: Management fees for the more actively traded bond funds can be higher, which may lead to lower returns.

In the second half of the year, we look for bond yields to continue to decline. The forces that have been pulling them lower—tightening monetary and fiscal policies—should continue. Treasuries with maturities of two years or longer likely will continue to decline.

Stocks and bonds deliver positive returns and cash underperforms both as the Fed pivots to rate cuts. Stocks and bonds may both be poised for success in 2024. Easing inflation and a pivoting Fed should reduce headwinds that have faced both asset classes in recent years.

Our current forecast in the short term is that the Fed will start cutting the federal-funds rate. We expect that to get down to a range of 3.75% to 4.00% by the end of the year. In fact, we expect that to continue to keep coming down in 2025, getting down to 2.25%.

Where to invest 2024?

Growth stocks may see a robust 2024 on the strength of trends such as AI disruption and decarbonization. Small-cap stocks are trading at attractive valuations as analysts see the possibility of a rebound in 2024. The time could be right for locking in rates on long-term, high-yield bonds.

When rates go up, bond prices typically go down, and when interest rates decline, bond prices typically rise. This is a fundamental principle of bond investing, which leaves investors exposed to interest rate risk—the risk that an investment's value will fluctuate due to changes in interest rates.

CDs are usually best for investors looking for a safe, shorter-term investment. Bonds are typically longer, higher-risk investments that deliver greater returns and a predictable income.

If sold prior to maturity, market price may be higher or lower than what you paid for the bond, leading to a capital gain or loss. If bought and held to maturity investor is not affected by market risk.

Even if the stock market crashes, you aren't likely to see your bond investments take large hits. However, businesses that have been hard hit by the crash may have a difficult time repaying their bonds.