2022 Marked the Worst Bond Year……
Ever! That’s right, last year was the worst year for Barclay’s U.S. Aggregate Bond Index, which is the most popular bond index, since its creation in 1976. Since that time, we’ve had very few (5 to be exact) negative years in the bond market.
So how bad was last year? The answer: historically bad. For perspective, the worst year in the index’s history came in 1994, when it was down -2.92%. Last year, that same index was down roughly -13%. That is a major deviation from its norm, to say the least. Now that we’ve lived to talk about this poor bond year, the question is why so historically bad, and what is next?
In almost 50 years we haven’t lived through this bad of a bond market in a given calendar year. The first question to answer, is why? To answer that let’s understand a few key things. For starters, interest rates and bond prices are inversely related. If you think of it logically, it makes sense. Most bonds are flat-rate bonds, meaning they’re issued with a flat interest rate (coupon) that they’ll pay over the life of the debt security. If I own a bond paying a flat 2% and the current interest rates (what new bond issues are based on) are let’s say 5%, why would I buy your 2% bond? The simple answer is only if I offered it to you at a hefty discount. Even if you hold a bond for its entire maturity, the daily value of that bond will fluctuate based on interest rates and credit quality. So, despite the fact that if you hold the bond to maturity you’ll get your principal back and interest along the way, market dynamics will move the underlying price of that bond daily.
Now let’s put these principles together, shall we? The Federal Reserve can use short-term interest rates to both stimulate and slow the economy. In the wake of COVID and the global economy shutting down, they pushed interest rates to the floor to help stimulate the recovery in economic activity by making money easy to access. For a real-life example, just turn to the real estate market. Heck, I have a mortgage right now at 2.125%, are you freaking kidding me! As great as that was for me at the time (and other home buyers or refinancers), keeping rates that low is only a temporary solution. Once inflation rose from the dead in 2021, easy monetary policy (low-interest rates) was going to begin unwinding.
We’ve spoken about the Fed’s dual mandate a lot over the last year, which is to say their two main objectives are to keep inflation low and positive (a 2% target) and unemployment low. With inflation clearly running hot since late 2021, what tool does the Fed have to combat that issue? You guessed it, they raise interest rates to slow our economy and temper inflation. Some perspective for you all, the Fed went into the year saying they’d raise interest rates likely 3 times for a total of .75% (each hike being 0.25%). With that in mind, the market largely didn’t budge as those expectations were absorbed pretty well. Instead, what happened? Welp, to temper inflationary concerns they ended up raising rates from near zero to 4.25%-4.5%. This included 4 consecutive meetings in which they raised rates by .75% each!
So here is what you saw transpire in 2022:
- Bonds had been at historically low rates for years.
- Inflation concerns hit us all like a ton of bricks.
- The Fed publicly goes on an all-out attack against inflation vowing to raise rates very aggressively.
- The entire bond industry was stuck playing catch-up all year with no apparent end in sight.
- Interest rates and bond prices are inversely correlated.
- A net result of 13% hit in the bond industry last year.
What is next?
Now that I’ve gone all doom and gloom on you folks, let’s talk silver lining, shall we? As we sit here looking forward, not back, at the bond market 2023 presents a totally different bond environment moving forward. For starters, and probably most importantly, inflation is slowly and steadily coming down. This says what the Fed is doing is working. Most economists are penciling in a total of a .75% interest rate hike this year to land at somewhere in the 5%-5.25% range.
There are a few reasons this is a good thing. Remember when I said if the Fed last year simply raised rates by .75% it was not a big deal? Always remember that markets price in expectations and move based on actual results being different from those expectations. It wasn’t just that the Fed hiked rates so aggressively, it’s that their expectations were set so differently and markets had to adjust very quickly to changing expectations. If the Fed does only move rates .50-.75% this year, the bond market should be able to keep its stride as it is what is already expected.
More importantly, a new issue bond is going to be at an interest rate you likely haven’t seen in decades. Thus, moving forward there is a great opportunity to gobble up very attractive bonds for a long period of time. Heck, look no further than your high-yield savings account, which mine is paying 3.5% on cash! Many industry experts are calling this a new chapter for bond returns moving forward. It really is remarkable that in the span of one year, the bond market went from the worst ever to a very attractive sector.
I’ve likened it to the fact we had to trudge through the muck to get to greener pastures. Today, that is where we likely sit – on greener pastures and clearer skies. Naturally, it would not be prudent to say all this without recognizing that anything can happen. If inflation stays stubborn, the Fed is likely to go more aggressively than where they are anticipating going. That said, I am of the opinion things would have to be much worse than projected for them to revert back to the hyper-aggressive environment we experienced last year. In fact, 2 weeks into the year the bond market is already showing some pleasant signs of a great year ahead.
I hope you enjoyed giving this a read and found it educational. Our job is not done because of one good or bad year. Rather, it is important I feel to educate as to what happened and why so you can be the smartest person in the room at your next cocktail party.
As always stay wealthy, healthy, and happy.
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