While the wild swings in the stock market tend to garner most of the headlines in the financial press, the more surprising return in 2022 was in the bond market. As of the writing of this column, the total return for the U.S. aggregate bond market is about negative 13%. If the bond market finishes the year somewhere in this range, it will rank as the worst calendar-year bond market return in about 100 years. Investors are used to stocks being volatile, but they generally expect their bonds to be kind of boring. For instance, in the last 40 years, the worst calendar year bond return was minus 3% in 1994.
Higher volatility in the bond market is a challenge for investors because, in general, investors rely on bonds for defense. Usually, bonds are fairly stable and often go up in value when the stock market goes down. Thus, they offer good diversification benefits. For instance, in 2008 and 2009, bonds provided positive returns to help offset stock declines during the great financial crisis. The bond market also went up in 2020 when the COVID crisis sent stocks down about 35%. But this year, bonds went down while stocks went down. What happened?
It’s all about interest rates and decisions by the Federal Reserve. In 2008, the Fed lowered interest rates to help spur economic activity. In 2020, they did the same thing. And when the Fed lowers interest rates, they make bonds that investors hold with higher interest rates more valuable. Thus, the price of the bonds already in the market tends to go up. But this year, the Fed did the opposite. Not only did they raise rates, but they increased them at one of the fastest paces in history. The rapid increase in rates pushed down the value of bonds already in the market. The change in interest rates has been so dramatic that it created one of the largest price declines in bond market history.
Does this mean that bonds might not provide much defense or help offset stock declines in the future? In finance, there are unusual events that fall outside the expected functioning of markets. 2022 was one of those years for bonds. If you figure this may be the worst decline for bonds in about 100 years, then this type of decline had roughly a 1% chance of occurring. That’s pretty small, but every so often, investors live the 1% event. It’s part of the risk of investing.
When evaluating portfolio strategies or asset class returns, investors should evaluate them over many different timeframes, not solely based on an outlier year. Lots of things can happen in a short period of time that are not indicative of what may happen over a longer cycle. And investing is about longer cycles, such as 10-, 15-, and 20-year cycles. For instance, the stock market can go down in shorter-term cycles all the time, but over the long term, it generally goes up as the economy grows.
So, when assessing bonds and the role they can play in portfolios, it’s helpful to think in multi-year cycles. Generally, higher-quality bonds provide a fair amount of defense and a steady stream of income payments to help manage risk in portfolios. It’s reasonable to expect they’ll generally do that going forward, but not every year or every time the stock market falls.
It’s also important to remember the income production. While bond prices may move around, as long as the issuer of the bond is financially healthy, investors should still receive their interest payments. The good news going forward is that the bond market provides more income than it did a year ago. If bond investors just sit back and collect the interest payments, those payments should help mitigate the declines in bond prices this year. Finally, if the Fed eventually gets control of inflation and lowers rates in the future, bond investors may again benefit from a price increase.
In general, investing in bonds is about collecting the interest payments and having some 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 look forward to some old-fashioned boring bond returns.
Charlie Farrell is a partner and managing director at Beacon Pointe Advisors LLC. The information contained in this article is for general informational purposes only. Opinions referenced are as of the publication date and may be modified because of changes in the market or economic conditions and may not necessarily come to pass. All investments involve risks, including the loss of principal.
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