When stocks zig, bonds are supposed to zag. That time-honored relationship has broken down over the past few years, but there are encouraging signs of its eventual return.

There’s no doubt that it’s been a challenging environment for fixed income. Losses in 2022 were particularly steep. It marked the first year in decades that bonds fell alongside stocks. Rapid rate increases by the U.S. Federal Reserve, against a backdrop of some of the highest inflation rates the U.S. economy has experienced in more than 40 years, caused massive upheaval. A look at the correlation between stocks and bonds during equity correction periods since 2010 shows just how unusual a period it was.

But as those rate hikes recede into the rearview mirror and markets increase their focus on the growth backdrop, fixed income may resume its role as a ballast in portfolios. In addition, higher starting yields mean higher return potential for bonds.

“This Fed hiking cycle has been the quickest that we've seen in decades, and it’s likely we’ll see interest rate sensitive segments of the economy soon experience challenges as a result,” says Chitrang Purani, fixed income portfolio manager for CGCB — Capital Group Core Bond ETF and American Balanced Fund®. “Economic weakening should generally be positive for bonds, both from the standpoint of absolute returns and diversification from equities.”

What went wrong?

The large increase in inflation and inflation expectations during 2022 drove a complete shift in expectations for Fed policy — both on the part of monetary policymakers and investors. In 2023, the year started off with optimism for bond returns as investors eyed relatively high starting yields. Yet the Bloomberg U.S. Aggregate Index has struggled to post gains this year as well, returning 0.40% through November 14.

The Fed’s actions have continued to loom large, as it raised rates by a total of 100 basis points this year — a slowdown from a 425-basis-point increase in 2022, but still higher than the Fed and markets expected coming into 2023. Although headline inflation has fallen dramatically from a peak of 9.1% in June 2022, it remains elevated at 3.2% as of October. Meanwhile, a much more resilient U.S. economy has led to continued shifts in expectations for not just the federal funds rate but interest rates across the maturity spectrum. A robust labor market, high pandemic-era savings and government stimulus are among the factors behind the economy’s resilience.

When can bond investors breathe easy again?

The Fed opted to skip rate hikes for two consecutive meetings this fall, with Fed Chair Jerome Powell reiterating that the agency will proceed “carefully” on future actions. He noted that the Fed has been watching a recent increase in longer term yields and that persistent changes in broader financial conditions could impact the path of monetary policy. This likely indicates that the Fed is at least close to done with its hiking cycle.

“It’s been easier for inflation to fall from peak levels last year to near 3% now than it will be to see it come back down to the Fed’s 2% target,” Purani says. “Given growth has been more resilient than most expected, interest rates are likely to remain ‘higher for longer,’ and that’s been reflected in the market this year.”

The higher-for-longer view anticipates that rates, while not necessarily rising much further, may stay at elevated levels for an extended period.

The additional repricing of interest rates higher in 2023 has created a more favorable risk/return balance for fixed income relative to a year ago. Returns are being aided by relatively strong starting yields, which recently touched a roughly 16-year high on the Bloomberg U.S. Aggregate Index.

“After the end of previous Fed hiking cycles, bonds have typically posted strong returns in the subsequent 12 months from a total return standpoint,” Purani explains. “That's historically been a good time to buy into fixed income.” Higher starting yields on their own may support an attractive return profile, but bonds have the potential to diversify against equity volatility with even stronger returns should economic growth materially deteriorate.

In the past four cycles, returns on the Bloomberg U.S. Aggregate Index have averaged 10.1% in the 12-month period following the Fed’s last hike. Current index yields have also closed the gap with three-month U.S. Treasury bills, which may cause investors to rethink holding cash-like investments in favor of bonds with greater interest rate exposure.

“Monetary policy lags seem longer this time around,” Purani says. “But if rates remain high, I believe it's more of a question of ‘when,’ not ‘if’ we’ll see economic weakness.”

That positive correlation of bond returns and stock losses in 2022 has left some investors questioning the value of rebuilding a fixed income allocation. Usually, correlation that is low/near zero indicates diversification, but that relationship was strained against the backdrop of sharply accelerating inflation and shifting monetary policy. However, a more benign outlook for inflation may enhance diversification going forward.

“When inflation is both high and rising, correlations tend to increase between bonds and equities,” Purani adds. “As inflation stabilizes or falls, bonds may act as a more reliable diversifier against equity weakness, even if inflation remains at somewhat more elevated levels than in the past decade.”

Where to focus in fixed income

Purani believes the risk of interest rate exposure in portfolios is better balanced. Duration, which measures a bond fund’s sensitivity to interest rates, could shift from a headwind to a tailwind for bond returns over the next year if rates are near their peak. Investors with a higher allocation to equities or other risky assets may want to increase their duration exposure, given better compensation today for rates exposure and the potential for price appreciation should the Fed cut rates in response to an economic downturn.

“Another consideration for investors to help make portfolios more resilient involves the credit quality of their bond investments,” Purani says. “Higher quality credits can be more insulated from economic weakness than their lower quality counterparts, which may be more likely to feel the effects of tighter monetary policy — and investors can add high-quality exposure without giving up much yield.”

Core bond funds may be a good option in this respect, assuming they don’t stray too far down the risk spectrum to chase higher yields. “It’s important to understand what you’re getting from your bond fund as many strategies that are benchmarked to diversified bond indices in theory may really be credit portfolios in practice,” Purani adds. “These funds may provide healthy yield if markets trend sideways, but they may correlate more with equities on the way down.” Looking at longer term historical return patterns during periods of equity market turmoil can also help shed light on diversification potential.

“When markets are volatile we aim to use diversified levers in the construction of bond portfolios to provide attractive risk-adjusted income and diversification,” Purani says. “It enables us to pursue attractive returns while still offering diversification to equities in periods of market stress.”

A more constructive outlook

After a long slump, bonds may finally be poised to resume their role as equity diversifiers in investor portfolios. Inflation is trending down. Concerns over reinflation appear to be moderating. The policy rate may be near — if not at — the peak. These factors all bode well for the risk/return prospects for bonds.

Investors looking to add balance through fixed income should consider a fund’s exposure to high-quality holdings and duration. A proven long-term track record of strong relative returns in down equity markets is also essential, though past results are not predictive of results in future periods.

“Nobody can have certainty in today’s outlook,” Purani concludes. “But over the next 12 months, high-quality fixed income has the potential to provide attractive opportunities from both a yield and total return standpoint, supporting its traditional role as a ballast within diversified portfolios.”