While wild swings in the stock market tend to grab headlines in the financial press, the most surprising performance in 2022 has been in the bond market. At the time of writing, the overall US bond market’s total return is around minus 13%. If the bond market ends the year somewhere in this range, it will rank as the bond market’s worst calendar-year return in about 100 years. Investors are used to stocks being volatile, but they generally expect their bonds to be a bit boring. For example, in the past 40 years, the worst calendar year bond yield was minus 3% in 1994.
Higher volatility in the bond market is a challenge for investors because, in general, investors rely on bonds to defend themselves. Usually, bonds are quite stable and often increase in value when the stock market goes down. Thus, they offer good diversification benefits. For example, in 2008 and 2009, bonds provided positive returns to help offset the decline in equities during the Great Financial Crisis. The bond market also rose in 2020 when the COVID crisis sent equities down around 35%. But this year, bonds have fallen while stocks have fallen. What happened?
Photograph by Ellen Jaskol
charlie farrel
It’s all about interest rates and Federal Reserve decisions. In 2008, the Fed lowered interest rates to help stimulate economic activity. In 2020, they did the same. And when the Fed lowers interest rates, it makes the bonds that investors hold with higher interest rates more valuable. Thus, the price of bonds already on the market tends to rise. But this year, the Fed did the opposite. Not only did they increase rates, they increased them at one of the fastest rates in history. Rapidly rising rates have driven down the value of bonds already in the market. The change in interest rates was so dramatic that it resulted in one of the largest price declines in bond market history.
Does that mean bonds might not provide much defense or help offset stock declines in the future? In finance, there are unusual events that come out of the expected functioning of the markets. 2022 was one of those years for bonds. If you think this might be the worst bond decline in about 100 years, then this type of decline had about a 1% chance of happening. It’s quite small, but once in a while investors experience the 1% event. This is part of the risk of investing.
When evaluating portfolio strategies or asset class returns, investors should evaluate them over many different time periods, not just on the basis of one outlier year. Many things can happen in a short period of time that are not indicative of what can happen over a longer cycle. And investing is about longer cycles, such as 10, 15, and 20 year cycles. For example, the stock market may go down all the time in short-term cycles, but in the long term it generally goes up as the economy expands.
So when evaluating bonds and the role they can play in portfolios, it helps to think in multi-year cycles. Generally, higher quality bonds offer good protection and a steady stream of income payments to help manage risk in portfolios. It’s reasonable to expect that they will generally do so in the future, but not every year or every time the stock market goes down.
It is also important to remember income generation. Although bond prices may change, as long as the bond issuer is in good financial health, investors should still receive their interest payments. The good news for the future is that the bond market is generating more income than a year ago. If bond investors are content to sit back and collect interest payments, those payments should help mitigate the decline in bond prices this year. Finally, if the Fed eventually gets inflation under control and lowers rates in the future, bond investors could once again benefit from higher prices.
In general, investing in bonds is all about collecting interest payments and having defensive holdings in your portfolio. It’s unusual for the Fed to make such drastic rate moves, but there could be more on the horizon until inflation is under control. After that, hopefully, we can expect some boring old-fashioned bond yields.
Charlie Farrell is Partner and Managing Director of Beacon Pointe Advisors LLC. The information in this article is for general information purposes only. The opinions referenced are valid as of the date of publication and may be changed due to changing market or economic conditions and may not necessarily materialize. All investments involve risk, including loss of capital.
