Bonds, typically one of the safest and most reliable investment tools, had a historically bad year in 2022, leading to lower returns for investors.
In yet another example of the volatility of the pandemic economy, bond markets took an uncharacteristic nosedive last year, largely due to the U.S. central bank’s efforts to tamp down record-high inflation rates.
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As economic headwinds such as soaring inflation and tightening monetary policy have played out in the past year, “bond markets have experienced their worst annual performance since the inception of Morningstar’s fixed-income indexes,” said Dave Sekera, the chief market strategist at Morningstar Research Services.
“In fact, looking at other indexes dating back to 1976, this year was the worst performance for fixed income ever,” Sekera wrote in December. “The Morningstar US Core Bond Index (our broadest proxy for the fixed-income market) fell 11.80% for the year to date through Dec. 12, 2022. No part of the fixed-income markets was spared, as rising interest rates across the entire bond yield curve pushed down bond prices.”
Edward McQuarrie, a professor emeritus at Santa Clara University’s Leavey School of Business, says inflation is “kryptonite” for bonds. “Even if you go back 250 years, you can’t find a worse year than 2022,” he told CNBC regarding bond markets.
The downturn illustrates how COVID-19 has upended the economy in ways that continue to reverberate throughout the financial sector and how the Federal Reserve’s campaign to control sky-high consumer prices with a series of aggressive interest rate hikes has affected markets more broadly.
“In 2022, the Bloomberg Barclay’s US Aggregate Bond Index, which represents the vast investible universe of US bonds, is set to do something it has never done before: lose value for the second year in a row,” investment firm Fidelity said in December. “Bond prices typically fall when yields rise, and as the Federal Reserve raised interest rates quickly and sharply to combat inflation, investors who feared falling prices sold bonds.”
Fidelity also noted how “bond markets have long been sensitive to changes in rates by central banks,” but that “they are also influenced by other factors such as the health of the economy and that of the companies and governments that issue bonds.”
“Since the global financial crisis, though, the interest rate and asset purchase policies of the Fed and other central banks have become by far the most important forces acting upon the world’s bond markets,” Fidelity continued. “In 2022, the focus of their policies shifted from supporting markets to trying to fight inflation, and bond markets reacted badly.”
But financial experts predict there’s some good news on the horizon — even with the potential for a recession. With recent inflation readings showing the start of a cooldown, the Fed is expected to slow the pace of its interest rate increases.
Those increases began in March, when the Fed started hiking interest rates for the first time in several years due to rising consumer prices. The central bank picked up the pace in June when data from the previous month showed inflation hitting its highest rate in more than four decades.
A strong labor market, pandemic-related government stimulus payments, and supply chain breakdowns, as well as record-high fuel prices tied in part to Russia’s invasion of Ukraine, had contributed to an overheated economy that drove the price of everyday goods to historic highs. U.S. stocks, for their part, responded to the inflation figures and the expected higher interest rate increase in the spring by entering bear market territory.
Since then, the central bank has approved several rate increases of three-quarters of a percentage point to try to cool overheated markets, leading to higher interest rates on everything from mortgages to credit card debt.
In December, the Fed’s forceful policy moves finally showed early signs of paying off. Fresh figures from the Department of Labor showed that inflation had grown at a slower pace than expected the month prior, marking two consecutive months of decline. As a result, the central bank cautiously approved a smaller interest rate hike of half of a percentage point — but warned that there could be economic pain on the horizon.
“Good riddance to 2022, at least from a financial perspective,” Allan Roth, a financial planner and founder of investment firm Wealth Logic, wrote in a Jan. 9 column for AARP. “Measured by the returns from low-cost index funds, the U.S. stock market lost 19.5 percent, while investment-grade bonds tumbled 13.2 percent. Inflation surged, running at an annual pace of 7.1 percent for the 12-month period that ended November.”
Roth said that it’s no surprise that stocks and bonds lost value last year since bear markets are part of the investing game. But “the magnitude of the losses in bonds was,” he said.
“High-quality bonds act as the shock absorber for your overall portfolio, but bonds lost nearly as much as stocks, even when you count reinvested interest,” Roth wrote. “Using a traditional statistical measure called standard deviation, the loss for the first three quarters of the year should happen about once every 50 million years,” Roth said, citing McQuarrie, the Santa Clara University professor emeritus. “While I don’t have the data for the full year, bonds didn’t recover much in the fourth quarter.”
Bonds lost value in 2022 as a result of surging interest rates, Roth said. “[I]t’s essential because people now want a higher interest rate return on their bonds, making existing bonds and bond funds with lower yields less valuable,” he wrote.
But, according to Roth, “the good part of this is that we can now earn far more on our bonds. Investment-grade bonds yielded 1.51 percent going into the year but closed the year yielding 3.88 percent. Today, you can buy a five-year bond known as the Treasury’s inflation-protected security (TIPS) that is guaranteed to beat inflation by 1.66 percent annually, whereas last year it was guaranteed to underperform inflation by 1.61 percent annually. TIPS are now even better than I bonds.”
Other financial experts agree that this year will be better for investors when it comes to bonds — and offer new investment possibilities.
Fidelity says that “bonds look poised to once again deliver their traditional virtues of reliable income, capital appreciation, and relatively low volatility” in 2023. “For the first time in decades, bond yields are high enough that income-seeking retirees can use them to help support a 4% withdrawal rate from their portfolios,” the firm wrote. “What’s more, bond funds could also have a comeback, propelled by higher yields, and possibly higher prices if the Fed cuts rates to help the economy come out of a potential recession later in the year.”
“Not only are yields up, but prices of many high-quality bonds are also down as a result of the 2022 selloff,” Fidelity added. “That means opportunities exist for those with cash to buy relatively low-risk assets at bargain prices even as they pay yields that are higher than they have been in decades.”
“Investors searching for good news have certainly found some,” Lisa Shalett, the chief investment officer in wealth management at Morgan Stanley, wrote in late November. “The latest consumer price index report suggested inflation may have peaked in October, and the Federal Reserve is perhaps now more likely to slow the pace of interest rate hikes.”
Shalett said investors “may be relatively well served by favoring bonds over stocks in 2023” for several reasons. First, “bond yields have meaningfully increased, providing investors an opportunity to earn decent income.”
“We expect inflation to be around 3.5% by the end of 2023, and U.S. Treasuries, through the 10-year maturity, are yielding more than that,” Shalett said. “That means their inflation-adjusted, or ‘real,’ yield could turn positive. Meanwhile, municipal and corporate bonds are providing an extra 1.5 to 2.5 percentage points beyond Treasury yields.”
“Bonds may offer attractive capital gains. Investors who are wary about the economy will likely gravitate toward Treasuries, which would push yields lower and prices higher, meaning it’s possible to enjoy relatively high coupon payments now and potentially sell at a premium later,” she said.
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Shalett said it’s too soon to say that the bear market period is completely in the rearview mirror. “Investors may have moved on from inflation concerns, but they cannot ignore the economic picture,” she wrote.
“For now, investors should consider reducing U.S. large-cap index exposure. Instead, look to Treasuries, munis, and investment-grade corporate credit,” she wrote. “Stay patient and collect coupon income.”
