Is This The Worst Year Ever For Bonds?

Key takeaways

• With the fear of a recession, investors are looking for a safe investment with a decent return.
• But, as bond yields rise, bond prices fall, hurting returns.
• Since the Fed kept interest rates at such low levels for so long, inflation spiked and interest rates are trying to catch up.

Historically, fixed-income securities have been a safe investment for investors looking to limit the risk associated with the stock market. You can invest in various durations of bonds and know that while there is a chance you could lose some money, the odds are in your favor.

That is until 2022 came around. This year could be the worst year in history for bonds. This article will examine why this is and what you can do as an investor to protect yourself.

How do bonds work?

Before we go any further, it’s essential to understand how bonds and bond pricing work. While on the surface they appear to be a simple investment, the way they work can be confusing for many investors.

A typical bond has a face value of $1,000, a coupon or interest rate and a maturity date. If you buy one bond with a 2% interest rate that matures in ten years, you initially pay $1,000. Then twice a year for the next ten years, you earn 2% interest on the $1,000 you invested. When the bond matures in ten years, you get your $1,000 investment back as well as the interest.

Where it gets confusing is the purchasing and selling of bonds on the secondary market. Here, the face value of the bond changes due to supply and demand. For example, let’s say an investor owns the same ten-year bond with an interest rate of 2%, and the Federal Reserve starts raising interest rates. New ten-year bonds have an interest rate of 4%. If you are investing in a bond, you’ll want the bond that pays the higher interest rate. As a result, the owner of the 2% bond sells it for less than face value.

The buyer, if they hold the bond to maturity, will earn 4%, plus the difference between their purchase price and the $1,000 face value. In theory, this combined amount should be around 4%, the new going rate for bonds.

The opposite scenario is also true, in which a 4% bond could sell for more than face value, assuming interest rates are much lower.

Finally, you should understand that bond prices and yields have an inverse relationship. When the price of a bond rises, the yield falls. When the price of a bond falls, the yield increases. Remember this when you see headlines that bond yields are rising due to high inflation. This means the bond prices are falling.

Why we invest in bonds

Now that we understand how bonds work, let’s look at why investors buy bonds. Traditionally, fixed-income securities present less risk and volatility. This is because they are debt instruments. Investors know the health of the company or nation issuing the bond and their return because of the stated interest rate. Also, you are first in line as a debt holder should the company go bankrupt. So while you aren’t guaranteed to get your money back, the odds are good that you will.

Since investing in stocks is much riskier, investors hedge the risk by investing a portion of their money in bonds. A popular allocation is 60% stocks and 40% bonds, also known as a balanced portfolio. Looking at the historical returns of an asset allocation of 100% stocks, you can expect to average a little more than 10% annually. With a 60/40 portfolio, your return is close to 9%.

But this doesn’t tell the entire story. A balanced portfolio is less volatile. With a 100% stock portfolio, a loss of over 43% is possible. With the 60/40 portfolio, losses tend not to exceed 28%. So while you slightly reduce your overall return by not investing completely in stocks, you decrease risk and volatility, substantially.

The worst year for bonds

2022 is shaping up to be the worst year by far for bonds. We touched on the reason why above. Currently, we are dealing with stubbornly high inflation. As the Federal Reserve increases interest rates, bond yields have to rise. When this happens, the price of bonds falls.

Since the Fed kept interest rates at such low levels for so long (among other reasons), inflation spiked and interest rates are trying to play catch up. The Federal Reserve felt inflation was transitory because of the pandemic. As a result, they missed the signs that inflation was here to stay and are now trying to course correct.

Looking back to 1977 using the Bloomberg US Aggregate Index, you can see that 2022 is the worst year for bonds. In 45 years, bonds have fallen in value only five times, and the most significant decline was 2.9% in 1994. In 2022, the bond index is currently down by more than 11%.

Using another data set from NYU, there has not been a double-digit decline in bonds since 1931, when they fell by 15%. This data covers corporate bonds and not the entire index as the Bloomberg index does, but it still gives you an idea of how much this year is an anomaly.

Should you still invest in bonds?

Even though bonds are having a bad year, they are still a smart asset class for your portfolio. What’s made this year unique is the combination of economic events all coming together at once. We have high government spending, supply chain issues, high consumer demand, lockdowns, high oil prices and the Russian invasion of Ukraine, all of which contribute to inflation. Add all this up and there is talk of a recession which will depress stock and bond prices for some time.

As the Federal Reserve raises interest rates to try to calm inflation, bond prices naturally fall, hurting investors’ returns. When there is uncertainty in the economy, investors tend to favor long-term bonds because they know they can get a specific return over the long run. This leads to an inverted yield curve, where yields are higher for short-term bonds than long-term ones.

Also during this time, Investors shy away from the stock market because the return they get is so uncertain, or so much lower than previously thought. They decide then to invest in bonds, where they are guaranteed to earn a specific return with little to no risk to the principal.

If you are a long-term investor, you should still make bonds part of your portfolio. If you are a short-term investor or need an income stream, there is an alternative.

Alternatives for investors

If bonds are losing money this year, where can you invest money that you know will be safe? One option is bonds. Short-term bonds, that is. As of right now, you can invest in short-term Treasuries known as bills, between three months and two-year terms, and earn close to 4% in interest. Because they have such a short duration, they aren’t affected as much as interest rates change. These bills are sold weekly directly from the Treasury Department.

Savvy investors can build a short-term Treasury ladder by purchasing these bills through a broker. Understand this means going through the secondary market, so that you will pay a different amount than the face amount. The upside is you have many more options in terms of duration. For example, you might purchase a three-month bill that matures in one month, essentially making it a one-month bill with a guaranteed return.

Finally, there are Q.ai Investment Kits, built atop artificial intelligence that scours the markets for the best investments for all manner of risk tolerances and investment levels. They also offer Portfolio Protection, an additional hedge against downside risk. This doesn’t eliminate the possibility of losses, but it can significantly lower your losses compared to the overall market. The kits all built around investment themes like emerging tech, clean tech, precious metals and value.

The bottom line

Bonds are a smart investment in most investors’ portfolios. They lower risk and volatility while still offering solid long-term returns. While this year is historically bad for bonds, you must keep things in perspective.

The bond market won’t always be historically bad, and as the Fed controls inflation, there should be stabilization in the bond market. Note that higher inflation could be here for some time, but as long as the Fed controls it, things should begin to settle down.

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