2022 was a remarkable year for financial markets. The fact that stocks experienced a bear market wasn't all that unusual, even coming on the heels of the quick plunge just two years earlier at the beginning of the COVID-19 pandemic in February 2020. What made the year extraordinary is that the bond market performed almost as badly as stocks did.

The damage to investors in the bond market was evident across the board. Even what many saw as being safer, less volatile plays on bonds turned out to be problematic. Yet heading into 2023, many market participants are more optimistic about the prospects for bonds to recover at least some of their losses from last year.

Number magnets spelling out 2023 on top of cash.

Image source: Getty Images.

Counting the toll

There weren't many places for bond investors to hide in 2022, as just about every type of bond investment performed poorly. Broad-based bond ETFs like the iShares Core U.S. Aggregate Bond and Vanguard Total Bond Market both posted declines of 13% in 2022, even after taking their interest payments into account.

The longer the maturity of the bonds that investors chose, the greater the declines typically were. Short-term bond investors managed to limit their losses, with the iShares 1-3 Year Treasury Bond ETF posting declines of just 4% in 2022. On the other hand, long-term bond investors got slammed hard, as the iShares 20+ Year Treasury Bond ETF plunged 31% last year -- again, even including interest payments.

High inflation rates played a key role in driving prices of conventional bonds lower, but even bonds designed to offer inflation protection weren't able to get the job done. The iShares TIPS Bond ETF invests in Treasury Inflation Protected Securities, and it lost 12% in 2022.

How things could turn around in 2023

The most obvious reason why 2023 could be better for the bond market than last year stems from pure mathematics. At the beginning of 2022, yields on three-month Treasury bills were at 0.06%, and two-year Treasuries yielded 0.75%. Even long-term rates were low, with 10-year Treasuries at 1.65% and 30-year bonds right around 2%.

Fast-forward to today, and short-term Treasuries are yielding 4.35% to 4.75%. Longer-term bonds have yields of roughly 3.7% to 3.8%.

Higher rates are good for 2023 bond returns for two reasons. One, even if rates stay where they are, you'll get a nice positive return from the interest your bonds generate. That's a big departure from how bonds have been throughout much of the past decade, with rock-bottom rates offering little or no current income.

Moreover, many see the potential for interest rates to go back down in 2023. Recessionary conditions often cause a drop in rates, and if that comes, you can add positive gains from rising bond prices to those interest payments to generate an even more impressive total return.

What investors can do

The easiest and potentially most valuable thing investors can do to take advantage of higher rates now is to make sure none of your cash is sitting idle. Americans have trillions of dollars in bank accounts paying no interest. For every $10,000 you have in a no-interest checking account, you're missing out on $400 to $500 of potential income in 2023, just by investing in ultra-safe short-term Treasury bills.

More broadly, investing in bonds is far more attractive this year than it has been for a while. That's no guarantee of strong returns for bonds in 2023, but it does mean that investors can feel a bit more comfortable about their bond allocations in the coming year and beyond.