As a lifelong Patriots fan, I subscribe to the do your job mantra. In a portfolio, every asset class has a job to do. For bonds, it’s to provide stability and income. And historically, it has done a good job. According to data from Schwab, since 1981, the Bloomberg Barclay’s U.S. Aggregate index has only ended a year with a negative total return four times. This year, all major bond indices are in the red. Investors with a diversified portfolio may be wondering why the bond market is down and questioning whether fixed income is doing its job.
Why is the bond market down?
Suffice it to say that 2022 has not been a good year for the bond market thus far. There are several reasons for this.
The Federal Reserve plans to end easy-money policy and raise interest rates. When interest rates rise, investors in the primary market earn higher coupons on new bond issues. This generally means outstanding bonds in the secondary market are worth less. The market has been pricing in multiple interest rate hikes all year, which is reflected in total returns, and one reason the bond market is down.
Inflation has been soaring due to fiscal stimulus which put a lot of cash in people’s pockets and a beleaguered supply chain which has been unable to keep pace with demand. When inflation is high, and bond yields are low, the real yield (inflation-adjusted) can be negative. Right now, real yields are -4%! This may cause some investors to rethink their investment strategy as it relates to fixed income.
The Federal Reserve is planning to raise interest rates aggressively to combat inflation. Getting inflation under control quickly without damaging the economy is not a simple task. There is concern that if the Fed raises rates too fast it could trigger an economic downturn or perhaps even a recession.
When investors have concerns about the economic outlook, it’s not just a matter of selling stocks and buying bonds or vice versa. Stocks are much better than bonds for combatting inflation over time, but when there’s a risk-off sentiment, bonds outperform. Right now, fixed income is outperforming stocks by being less negative on a relative basis.
Right now, like always, there are multiple narratives at play in the markets. But the primary reason bonds are down this year is because the Federal Reserve is going to be raising rates.
Is fixed income doing its job?
Individuals sometimes forget that like any investment, when you buy bonds you take on market risk, including loss of principal. Put another way: like stocks, bonds go down also. However, year-to-date, bonds are less negative than most equities. Meaning fixed income is doing its job.
In volatile markets, there isn’t always somewhere to hide. But diversification is still working, especially globally. Over the last 10-15 years, U.S. assets have largely outperformed their ex-U.S. counterparts. But there’s no signal for when and how that begins to shift. As the chart above illustrates, year-to-date, international stocks and bonds have outperformed U.S. assets. Compared to the tech-heavy NASDAQ, ex-U.S. stocks have curbed losses by over 10%. This is a great example of the importance of holding a diversified mix of stocks and bonds in your portfolio.
Looking at the first table in this article, you can see that core U.S. bond indices (treasuries and the aggregate) are close to their historical max drawdowns. The more volatile bond sectors (ex-U.S. and U.S. corporate) are still well below their max drawdowns.
In either case, investors should always be ready for volatility in the short-term while focusing on maintaining an asset allocation that’s suitable for your time horizon.
Examples in this article are generic, hypothetical and for illustration purposes only. Both past performance and yields are not reliable indicators of current and future results. All indexes are unmanaged and an individual cannot invest directly in an index. Index returns do not include fees or expenses. This is a general communication for informational and educational purposes only and not to be misinterpreted as personalized advice or a recommendation for any specific investment product, strategy, or financial decision. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. If you have questions about your personal financial situation, consider speaking with a financial advisor.