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

While stocks perked near the end of 2023 on news that the Federal Reserve might be done with interest rate hikes, there’s no doubt that the last couple of years have been challenging 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 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. The chart to the right, depicting 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 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, a Capital Group fixed income portfolio manager. “Economic weakening should generally be positive for bonds, both from the standpoint of absolute returns and diversification from equities.”

The Fed’s actions have continued to loom large. After raising rates by a total of 1 percentage point in 2023, it signaled in December that it was mulling potential cuts this year, as inflation — though still elevated — had fallen significantly from its recent highs. Meanwhile, a much more resilient U.S. economy has led to continued shifts in expectations for not just the federal funds rate but for 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.

Bond investors might be able to breathe easy again.

The Fed opted to skip rate hikes for its last three meetings of 2023 and projected up to three potential cuts this year. Fed Chair Jerome Powell cautioned that this is a forecast, subject to change if conditions shift. Still, these are strong signals that the Fed is likely done, or close to done, with its hiking cycle.

“It’s been easier for inflation to fall from peak levels to near 3% 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 in 2023.”

The higher-for-longer view anticipates that rates, while potentially shifting a little up or down, 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 the end of 2022. 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.

Some investors have been questioning the value of rebuilding a fixed income allocation after bonds fell alongside stocks in 2022. Historically, core bonds haven’t moved in tandem with stocks, 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.”

Core bonds appear attractive.

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 this 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. 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, Purani adds.

The outlook is constructive.

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.”