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

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The simple “first five days” stock market indicator is poised to send a good omen for 2023

Traders on the New York Stock Exchange on December 21, 2022.

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The bond market suffered a major collapse in 2022.

Bonds are generally viewed as a boring, relatively safe part of an investment portfolio. They have historically been a shock absorber, buoying portfolios when stocks plummeted. But that relationship ended last year, and bonding was anything but boring.

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In fact, it was the worst year on record for US bond investors, according to an analysis by Edward McQuarrie, a professor emeritus at Santa Clara University who studies historical investment returns.

The implosion was largely due to the Federal Reserve aggressively raising interest rates to combat inflation, which peaked in June at its highest level since the early 1980s and arose from a mix of pandemic-era shocks.

In short, inflation is “kryptonite” for bonds, McQuarrie said.

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

This analysis focuses on “safe” bonds, such as US Treasuries and investment-grade corporate bonds, he said, and applies to both “nominal” and “real” yields, that is, yields before and after accounting for inflation.

Let’s take the Total Bond Index as an example. The index reflects US investment grade bonds, ie corporate and government bonds that have a low risk of default according to rating agencies.

The index lost more than 13% in 2022. The index had previously suffered its worst 12-month return in March 1980, when it fell 9.2% in nominal terms, McQuarrie said.

This index dates back to 1972. We can look further back with various bond barometers. Because of bond dynamics, yields deteriorate more for those with the longest time horizon or maturity.

For this reason, some fund managers expect a rebound in bonds

For example, intermediate-dated Treasuries fell 10.6% in 2022, the biggest decline on record for Treasuries since at least 1926, before which monthly Treasuries are somewhat patchy, McQuarrie said.

The longest US government bonds have a maturity of 30 years. Such long-dated US notes lost 39.2% in 2022, as measured by an index that tracks long-dated zero-coupon bonds.

That’s a record low from 1754, McQuarrie said. For the second worst result one would have to go back to the Napoleonic War era when long bonds lost 19% in 1803 arguably safer than those issued by the US

“What happened in the bond market last year was staggering,” said Charlie Fitzgerald III, a board-certified financial planner based in Orlando, Florida. “We knew something like this could happen.”

“But actually seeing it was really hard.”

Why bonds collapsed in 2022

It’s impossible to know what’s in store for 2023 — but many financial advisers and investment experts think it’s unlikely that bonds will do anywhere near as badly.

While returns won’t necessarily turn positive, bonds are likely to reclaim their place as a portfolio stabilizer and diversifier relative to equities, the advisers said.

“Bonds are more likely to behave like bonds and stocks like stocks: when stocks go down, they might move very, very little,” said Philip Chao, chief investment officer at Experiential Wealth, based in Cabin John, Maryland.

Interest rates started 2022 at a low – where they had been for most of the time since the Great Recession.

The US Federal Reserve cut borrowing costs to near zero again early in the pandemic to prop up the economy.

But the central bank reversed course from March. The Fed raised interest rates seven times last year, to between 4.25% and 4.5%, which was its most aggressive policy since the early 1980s.

This had huge consequences for bonds.

Bond prices move inversely with interest rates – when interest rates rise, bond prices fall. Basically, that’s because the value of a bond you’re holding now will fall as new bonds are issued at higher interest rates. These new bonds, because of their higher yield, deliver higher interest payments, making existing bonds less valuable – lowering the price of your current bonds and dampening investment returns.

Additionally, bond yields in the second half of 2022 were among their lowest in at least 150 years — meaning bonds were their most expensive by historical standards, said John Rekenthaler, Morningstar’s vice president of research.

Fixed income fund managers who bought expensive bonds ended up selling them low as inflation surfaced, he said.

“A more dangerous combination for bond prices can hardly be imagined,” wrote Rekenthaler.

Why Long-Term Bonds Have Been Hit Hardest

Bonds with longer maturities took a particularly bad beating. Think of the maturity date as the term or holding period of a bond.

Bond funds that hold bonds with longer maturities generally have a longer “duration”. The duration is a measure of the interest rate sensitivity of a bond and is influenced by the term, among other things.

Here’s a simple formula to demonstrate how it works. Let’s say a medium-term bond fund has a duration of five years. In this case, we would expect bond prices to fall 5 percentage points for every 1 point increase in interest rates. The expected drop would be 10 points for a 10-year fund, 15 points for a 15-year fund, and so on.

We can see why long-dated bonds suffered particularly large losses in 2022 as rates jumped about 4 percentage points.

2023 looks brighter for bonds

However, the dynamic seems to be different this year.

The Federal Reserve is poised to raise interest rates further, but the hike likely won’t be as dramatic or as rapid — in which case the impact on bonds would be more muted, advisers said.

“There’s no way in God’s green earth is the Fed going to have rate hikes as fast and as many as 2022 has,” said Lee Baker, an Atlanta-based CFP and president of Apex Financial Services. “When you go from 0% to 4%, it’s devastating.”

This year is a whole new scenario.

Cathy Curtis

Founder of Curtis Financial Planning

“We’re not going to go to 8%,” he added. “There’s just no way.”

In December, Fed officials forecast that they would hike rates up to 5.1% by 2023. This forecast could change. But it seems most of the losses in fixed income are behind us, Chao said.

Also, bonds and other types of “fixed income” are entering the year, providing investors with much higher yields than they did in 2021.

“This year is a whole new scenario,” said CFP Cathy Curtis, founder of Curtis Financial Planning, based in Oakland, California.

Here’s what you should know about bond portfolios

Amid the big picture for 2023, don’t give up on bonds given their performance over the past year, Fitzgerald said. They still play an important role in a diversified portfolio, he added.

The traditional dynamic of a 60/40 portfolio — a portfolio barometer for investors weighted 60% equities and 40% bonds — is likely to return, advisors said. In other words, bonds would likely act as ballast again when stocks fall, they said.

Over the past decade, low bond yields have prompted many investors to increase their equity allocations to meet their target portfolio returns — perhaps to a 70/30 versus 60/40 total allocation to stocks and bonds, Baker said.

In 2023, it might make sense to scale back equity exposure back into the 60/40 range — which given higher bond yields could achieve the same target returns but with less investment risk, Baker added.

As the magnitude of future interest rate moves remains unclear, some advisors recommend holding more short- and intermediate-dated bonds, which carry less interest-rate risk than longer ones. The extent to which investors do this depends on their timetable for their funds.

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For example, an investor saving to buy a home next year might park some money in a certificate of deposit or a US Treasury bond with a term of six, nine, or 12 months. High-yield online savings accounts or money market accounts are also good options, according to the consultants.

Cash alternatives are generally paying around 3% to 5% right now, Curtis said.

“I can leverage clients’ money allocation to ensure reasonable returns,” she said.

Going forward, however, it’s not as wise to be overweight short-dated bonds, Curtis said. It’s a good time to start investing in more typical bond portfolios with a medium-term duration of, say, 6-8 years instead of 1-5 years as inflation and interest rate hikes appear to be abating.

The average investor can invest in an aggregate bond fund such as the iShares Core US Aggregate Bond Fund (AGG), for example, said Curtis. The fund had a duration of 6.35 years on January 4th. Investors in high tax brackets should buy an entire retirement fund in a retirement account rather than a taxable account, Curtis added.