These bond funds are among the top performers in 2023 – Here’s what investors should do next

It's been a good year for yield-chasing investors willing to take some risk in fixed income. The Federal Reserve's rate hikes since March 2022 have had the pleasant side effect of lifting yields on interest-bearing assets ranging from Treasury bills to money market funds. The lowly 1-year certificate of deposit is yielding more than 5% at several online banks. Consider that the benchmark 10-year Treasury yield went from about 3.9% at the start of 2023 to top 5% in October. (Yields move inversely to bond prices.) US10Y US3M YTD line Yields on the 10-year Treasury note vs 3-month T-bill in 2023 The zoom higher in bond yields has been brutal on longer-dated issues – the long government U.S. fund category has a year-to-date total return of -6.21% through last Friday, according to Morningstar – but it's been a boon for short-term instruments. “With yields rising, any category or asset class with long durations underperformed, and any category with short duration did well,” said Thomas Murphy, fixed income strategies analyst at Morningstar. Duration is a measurement of a bond's price sensitivity to changes in interest rates, and longer-dated bonds have greater duration. Indeed, this year's environment, including the favorable setup for short-duration instruments, lifted bond funds in three key categories: bank loans, high yield and ultrashort, according to data from Morningstar. Bank loans The U.S. bank loan funds category had a 2023 total return of 9.81% through last Friday, according to Morningstar. These offerings invest in floating rate loans from banks and other financial institutions. The quality of the underlying holdings can vary – consider that the T. Rowe Price Floating Rate fund (PRFRX) has roughly 57% of its holdings rated B and 4.5% rated CCC and below. But the duration tends to be short: PRFRX's weighted average duration is 0.62 years. The payoff is attractive for shareholders who are willing to take the additional risk: PRFRX offers a 30-day SEC yield of 8.78% and has an expense ratio of 0.78%. “We saw those high yield bonds and bank loans, those asset classes rooted with credit risk staying strong, and corporate fundamentals have held in,” said Murphy. “So it's been a good year for those.” Risk-taking investors also fared well in high-yield bonds, as the fund category generated a 2023 total return of 6.98% through Friday. Big performers in that category include the Pacific Income Advisors High Yield (MACS) Fund (PIAMX) for investors with managed accounts. Through last Friday, the fund had a total return of 11.9% in 2023, according to Morningstar. PIAMX offers a 30-day SEC yield of 10.72% and carries an expense ratio of 0.21%. The BondBloxx CCC Rated USD High Yield Corporate Bond ETF (XCCC) was also among the strongest performers in the fund category. It offers a juicy 30-day SEC yield of 13.94%, provided investors are comfortable with the credit and default risk that comes with the underlying CCC-rated issues. The expense ratio is 0.4%. See below for a list of top performing high yield bond funds, according to Morningstar Direct. Ultrashort bond portfolios tend to hold investment grade bonds but keep duration below a year. That means their prices are less sensitive to changes in rates. The VanEck CLO ETF (CLOI) invests in investment grade slices of collateralized loan obligations, and though it's only been around since June 2022, it's offering promising year-to-date returns of more than 8% and a 30-day SEC yield of 6.32%. The expense ratio is 0.4%. See below for a list of this year's top ultrashort performers, per Morningstar Direct. A critical year-end decision With 2024 looming, fresh portfolio worries may need to be addressed. For instance, fed funds futures pricing data indicates a higher likelihood of rate cuts through 2024. If coupled with a recession, that could issue a 1-2 punch for those high-returning bond fund categories: Falling rates expose investors to reinvestment risk, while an economic downturn could threaten companies that issue riskier debt. Now might be a good time for investors to check their risk appetite and consider whether they should take some of those winnings off the table and reassess their fixed income holdings. That might mean gradually adding a little more duration exposure to prepare for rate cuts and trading up in quality before any recession. The intermediate core bond space has held up well in economic downturns , offering investors a combination of longer duration, high quality and diversification – even as the category has a total return of 0.81% in 2023, per Morningstar. “I think these historically high yields have offered attractive entry points for high quality,” said Murphy. “Diversification and high quality are important, and so is knowing what you own.” “Even if you stay patient in a category like high yield bonds, managers out there will have large exposures to triple-C issues and below, and those are the bonds that are going to get hit worse if things turn south on us,” he added.