2022 was one of the worst years to be a fixed-income investor. Aggressive interest rate hikes sent bond yields soaring, which caused the price of fixed-income assets — especially longer-duration issues — to plummet. Investors holding a traditionally balanced 60/40 portfolio of stocks and bonds suffered their deepest drawdowns in decades.
Throughout 2022, the benchmark 10-year Treasury yield climbed steadily upward, from a low of 1.6% at the beginning of the year to 3.9% by Dec. 30. The popular Bloomberg Aggregate U.S. Bond Index, a barometer of overall U.S. fixed-income performance, shed 14% by year-end, delivering its worst one-year performance since its inception in 1977.
Still, bonds remain an indispensable part of a diversified investment portfolio. Ted Stephenson, professor of accounting and finance at George Brown College, notes that “regardless of correlation, bonds have done well versus stocks in six out of seven historical recessions. Ultimately, the correlation between stocks and bonds is not as important as relative performance.”
“The 2023 outlook is drastically different than the position we found ourselves in last year,” says Paul Malloy, head of municipals at Vanguard. Indeed, fixed-income investors started 2022 with a near-zero federal funds rate, but are now entering 2023 with a rate of 4%-plus. According to Malloy, the Federal Reserve “front-loaded” much of its policy tightening this cycle and is likely close to the end.
Malloy is overall optimistic about fixed-income returns moving forward. “Interest rates are now high enough to provide attractive yields. Now, you’re paid to wait for economic downturns. If recession risks are realized, fixed income will play its traditional countercyclical role as a ‘flight to quality,’ thus enjoying stronger price appreciation.”
With this in mind, here’s what other experts think are the five best fixed-income funds to buy in 2023:
— WisdomTree Floating Rate Treasury Fund (ticker: USFR) — Vanguard Emerging Markets Government Bond ETF (VWOB) — Vanguard Federal Money Market Fund (VMFXX) — iShares 1-3 Year Treasury Bond ETF (SHY) — Vanguard Intermediate-Term Investment-Grade Fund Admiral Shares (VFIDX)
WisdomTree Floating Rate Treasury Fund (USFR)
USFR tracks the performance of the Bloomberg U.S. Treasury Floating Rate Bond Index, which holds a portfolio of short-term floating-rate Treasury notes. Floating-rate Treasurys are unique, as the size of their coupon payments can vary depending on a reference rate, which is based on the high yield determined at the weekly auction of 13-week Treasury bills.
Therefore, if Treasury yields rise, then floating-rate Treasury investors will earn better returns. Darin Tuttle, chief investment officer at Tuttle Ventures LLC, likes USFR, stating, “In our view, USFR helps bridge an important gap between short-maturity Treasury bills and longer-maturity, fixed-rate Treasury bonds, as a core alternative with reduced interest rate and credit risk.” The ETF charges a 0.15% expense ratio.
Vanguard Emerging Markets Government Bond ETF (VWOB)
Investors willing to look outside of the U.S. bond market can also find attractive opportunities. “By investing in emerging market bonds, you’re getting 70% of long-term stock market returns for approximately 55% of stock market risk, as measured by the historical returns and standard deviation of both asset classes,” says Taylor Sohns, co-founder of LifeGoal Investments.
Sohns recommends VWOB, which holds 754 government-issued bonds from countries like China, Mexico, the United Arab Emirates and Turkey. Currently, the ETF has a yield-to-maturity of 7.4%, which is much higher than U.S. government Treasurys with a similar duration. However, the overall credit quality is lower compared with U.S. bonds. VWOB charges an expense ratio of 0.2%.
Vanguard Federal Money Market Fund (VMFXX)
Low-risk investors seeking preservation of capital and high liquidity can consider VMFXX, which seeks to maintain a stable net asset value, or NAV, of $1. Money market funds like VMFXX are as conservative as it gets. Thanks to rising interest rates, VMFXX currently has a seven-day SEC yield of 4.2%. The fund charges a 0.11% expense ratio and requires a $3,000 minimum investment.
Michael Ashley Schulman, partner and chief investment officer at Running Point Capital Advisors, likes VMFXX. “Based on the yield curve’s distinct shape, which is currently inverted with six-month T-bill yields near 4.7% and 10-year yields almost 1% lower at 3.8%, we would be (and have been) large buyers of short-term government bonds in the three-month to nine-month range,” Schulman says.
iShares 1-3 Year Treasury Bond ETF (SHY)
While recessionary risks appear to be on the horizon, other experts believe that further Fed hikes are still looming. “In my view, inflation will likely be somewhat sticky, so you may be better positioned by staying with limited maturities,” says David James, managing director at Coastal Bridge Advisors. “Today, the two-year Treasury yields 4.3%. We believe that is pretty attractive to most investors.”
James suggests using a low-cost index fund that invests in one- to three-year Treasurys. A possible candidate is SHY, which tracks the ICE US Treasury 1-3 Year Index and currently has an effective duration of 1.8 years, giving it relatively low interest rate sensitivity. Currently, SHY has an average yield to maturity of 4.5%. The ETF currently has assets under management, or AUM, of $27 billion and an expense ratio of 0.15%.
Vanguard Intermediate-Term Investment-Grade Fund Admiral Shares (VFIDX)
Income-oriented investors willing to accept greater credit risk for higher yields can target investment-grade corporate bonds, which are those rated BBB or higher by Standard & Poor’s. As Andy Kapyrin, director of research at RegentAtlantic Capital, notes: “For the first time since the 2008 great financial crisis, investors can now receive yields of 5% to 6% on a portfolio of investment-grade corporate bonds.”
Kapyrin recommends VFIDX, which holds a portfolio of corporate bonds, pooled consumer loans, and government bonds with an average maturity of five to 10 years, an intermediate duration of 6.3 years and a yield to maturity of 5.2%. “2022’s surge in rates means that bonds can move beyond just being a source of stability to also producing meaningful investment returns again,” Kapyrin says.
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Update 01/04/23: This story was published at an earlier date and has been updated with new information.