2022 was the worst-ever year for U.S. bonds. How to position for 2023

The bond market has suffered a major meltdown in 2022.

Bonds are generally considered a boring and relatively safe part of an investment portfolio. They’ve historically been shock absorbers and helped keep portfolios afloat when stock prices plummeted.

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In fact, it was the worst year ever for U.S. bond investors, according to an analysis by Edward McCurry, professor emeritus at Santa Clara University who studies historical investment returns.

The implosion was largely due to aggressive interest rate hikes by the U.S. Federal Reserve to combat inflation, which reached its highest level since the early 1980s in June, amid the pandemic era. resulting from the fusion of the shock of

Inflation is essentially the “kryptonite” of bonds, McCurry said.

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“Even if you go back 250 years, you won’t find a worse year than 2022,” he said of the US bond market.

Its analysis concentrates on “safe” bonds, such as U.S. Treasuries and investment-grade corporate bonds, and applies to both “nominal” and “real” returns, i.e. before and after adjusting for inflation, he said. rice field.

As an example, let’s look at the Total Bond Index. This index tracks US investment grade bonds. This refers to corporate and government debt that credit rating agencies deem low risk of default.

The index is down more than 13% in 2022. Prior to that, on a nominal basis he fell 9.2% in March 1980, when the index had posted its worst return in 12 months, McCurry said.

That index dates back to 1972. You can go even further back using various bond barometers. Due to bond dynamics, bonds with the longest duration or maturity yield worse returns.

Medium-term government bonds, for example, fell 10.6% in 2022. This is the largest decline on record for U.S. Treasuries going back to at least 1926, he said, and the monthly financial data before that has been a bit spotty, McQuarrie said.

The longest US Treasury bond maturity is 30 years. Such long-term US Treasuries have fallen 39.2% in 2022, as measured by an index that tracks long-term zero-coupon bonds.

This is the lowest recorded since 1754, McQuarrie said. When long-term government bonds fell his 19% in 1803, we have to go back to the Napoleonic Wars era. McQuarrie said the analysis uses British government bonds issued before 1918 as a barometer.Definitely more secure than US issued

“What happened in the bond market last year was tectonic,” said Charlie Fitzgerald III, a certified financial planner based in Orlando, Florida. I knew.”

“But it was really hard to actually see it in action.”

It’s impossible to know what’s in store for 2023, but many financial advisers and investment professionals think it’s unlikely that bonds will fare so badly.

Bonds are likely to reclaim their place as portfolio stabilizers and diversifiers compared to equities, advisers said, although returns aren’t necessarily positive.

“Bonds are likely to behave like bonds and stocks like stocks,” said Philip Zhao, chief investment officer at Experienced Wealth, based in Cabin John, Maryland. Even if it falls, it will hardly move,” he said.

Interest rates have started rock bottom in 2022. It has been at this level for most of the period since the Great Recession.

The US Federal Reserve once again cut borrowing costs to near zero at the beginning of the pandemic to support the economy.

However, the central bank has reversed course since March. The Federal Reserve (Fed) raised its benchmark interest rate seven times last year, from 4.25% to 4.5%, the most aggressive policy move since the early 1980s.

This was very important for bonds.

Bond prices move inversely to interest rates. When interest rates rise, bond prices fall. Fundamentally, as new bonds are issued at higher interest rates, the value of the bonds you currently hold will decrease. These new bonds offer more interest payments thanks to higher yields, reducing the value of existing bonds. As a result, the price of current bonds will fall, lowering investment returns.

What’s more, bond yields in the second half of 2022 are at their lowest in at least 150 years, which means bonds are at their highest historically, said John Rekenthaler, vice president of research at Morningstar. I’m here.

When inflation started to surface, bond fund managers who bought expensive bonds ended up selling them at lower prices, he said.

“I can hardly imagine a more dangerous combination of bond prices,” Rekenthaler wrote.

Bonds with longer maturities have particularly failed. Think of the maturity date as the term or holding period of the bond.

Bond funds that hold longer-term bonds generally have longer “durations.” Duration is a measure of a bond’s sensitivity to interest rates and is affected by maturity among other factors.

Here’s a simple formula to show how this works. Suppose the duration of the medium-term bond fund is his five years. In this case, for every 1 point rise in interest rates, bond prices are expected to fall 5 percentage points. The expected decline is 10 points for a fund with a duration of 10 years, 15 points for a fund with a duration of 15 years, and so on.

Considering that interest rates have risen by about 4%, we can see why long-term bonds suffered particularly heavy losses in 2022.

However, the dynamic seems to be different this year.

The U.S. Federal Reserve is poised to continue raising rates, but it is unlikely that they will be so dramatic or rapid, in which case the impact on bonds would be more muted, advisers said. .

Lee Baker, President of Apex Financial Services at Atlanta-based CFP, said: “When you go from 0% to 4%, it’s catastrophic.”

“We’re not going to 8%,” he added. “it’s no use.”

In December, Fed officials predicted a 5.1% rate hike in 2023, but that forecast is subject to change. But most of the bond losses seem to have passed, said Zhao.

Additionally, bonds and other types of “bonds” have entered the year, giving investors much stronger returns than they did in 2021.

“This year is a whole new scenario,” said Kathy Curtis of CFP, founder of Oakland, Calif.-based Curtis Financial Planning.

Don’t abandon bonds given last year’s performance in the big picture for 2023, Fitzgerald said.

The traditional dynamics of 60/40 portfolios — portfolio barometers for investors that weight equities 60% and bonds 40% — are likely to make a comeback, advisers say. In other words, if equities fall, bonds are likely to act as ballast again, they said.

Over the past decade or so, low bond yields have forced many investors to increase their allocations to equities to achieve their portfolio return targets. Perhaps the overall allocation between stocks and bonds will be 70/30 versus 60/40, Baker said.

In 2023, it may make sense to move equity exposure back into the 60/40 range again, which Baker says could achieve the same target returns given higher bond yields, but He added that the investment risk would be reduced.

Given that the range of future interest rate movements remains uncertain, some advisers recommend holding short-term and medium-term government bonds, which carry less interest rate risk than long-term government bonds. The extent to which investors do so depends on the funding timeline.

For example, an investor saving to buy a home next year can put some money in a Certificate of Deposit or a US Treasury note of 6, 9, or 12 months. High-yield online savings and money market accounts are also good options, advisers said.

Alternative cash generally pays around 3% to 5% now, Curtis said.

“You can get your client’s cash allocation to work and get a decent return safely,” she said.

Going forward, however, Curtis said it would be unwise to overweight short-term bonds. Given that inflation and rate hikes appear to be easing, start investment positions with more typical bond portfolios with intermediate durations, say 6-8 years, rather than 1-5 years It’s a good time for

The average investor is the iShares Core US Aggregate Bond Fund (AGG), for example Curtis said. The fund’s duration was 6.35 years as of Jan. 4. Curtis added that high-tax investors should buy total bond funds in retirement accounts rather than taxable accounts.