You’ve probably seen the headlines about how badly the stock market has performed so far in 2022.
“Worst first half of a year in the last fifty years.”
The broadest index of world stocks declined over 21% through June 30, 2022, caused in part by the highest inflation in 40 years and the largest land war in Europe in 80 years.
And the outlook for the rest of the year appears similarly bleak, with many predicting worldwide recession as the US Federal Reserve and other central banks raise interest rates quickly in an effort to stem inflation.
Less publicized, but in many ways much more surprising, has been the decline in bond prices, with the broadest index of US bonds down over 10% through June 30th.
This is the largest drop for bonds since 1994. And it has reversed a trend from recent periods of stock market declines, including 2000-2002 and 2007-2009, when bond prices rose and were widely viewed as a buffer against stock volatility.
Here’s a summary of how bonds work and what it means for you.
Bonds are one of the main ways companies and governments raise funds to do their work. Stocks are the other.
Bond issuers borrow money from investors over a period of time (the “term”), promising to pay the investors periodic interest and return the money at the end of the term (or “maturity”).
This is why bonds are considered debt for companies and governments, while stocks are considered “equity,” or ownership stakes, in companies. Governments generally don’t offer stock.
The interest rate that bond issuers pay to investors is typically determined in the bond market (the Fed sets short-term rates for banks).
Very stable issuers, like the US federal government and well-established corporations, generally pay less in interest than local governments or less successful companies, because the risk of default on the interest payments and/or principal repayment is lower. This factor is often referred to as “credit quality.”
Shorter-term bonds typically pay less interest than longer-term bonds because the investor has an opportunity to reinvest funds more quickly after the bonds mature.
Another key concept for bond investors is that there are two components of total return for bonds: one is income, represented by the interest rate the issuer pays out, and the other is price change, which can be positive or negative.
This is also true for stocks (and almost all other investments), where income is earned as dividends. Stock price changes typically have wider ranges, both up and down, than for bonds.
Interest income typically represents the main part of total bond returns and is fairly straightforward: for most bonds, issuers pay investors the stated interest rate a few times each year.
Price changes for bonds are less intuitive: as market interest rates rise, typically due to factors such as positive economic growth and rising inflation, the prices of existing bonds, with lower fixed rates, decline.
As market interest rates fall, typically due to factors such as negative economic growth (i.e., recession) and lower inflation, the prices of existing bonds, with higher fixed rates, rise.
This “inverse” relationship between rates and prices causes much confusion but is very important in understanding your bond investments.
The latter scenario (i.e., lower rates/higher prices) characterized the bond market for most of the past three decades. Interest rates stayed relatively low, and bond prices rose.
Since the start of 2022, on the other hand, interest rates (represented by the 10-year US Treasury bond, which often serves as a benchmark for the broader bond market) have risen from 1.5% to almost 3.5% in mid-June.
This very rapid increase has led to the severe bond price declines through June.
Implications and Advice
Interest rates have fallen back to around 3% from the 3.5% high, and bond prices have recovered somewhat, especially in comparison with stock prices.
While bonds and stocks declined by almost equal amounts through March 31, 2022 (with bonds down 6% and stocks 5.5%), stocks had fallen twice as much as bonds through June 30th (down 20% and 10%, respectively).
For the longer-term, rising rates generally have positive implications since they are usually associated with periods of economic growth. Higher rates also typically offset bond price declines over time, providing a “self-correcting” mechanism for bonds that stocks lack.
But all of this is cold comfort for most bond investors, who have come to expect the “fixed income” part of their portfolios to churn out regular interest income with little or no volatility, especially on the downside.
Despite these short-term setbacks, for bonds as well as stocks, we continue to advocate for broadly diversified portfolios for long-term investors.
As Jeff Sommer, a New York Times business columnist whom we regularly cite, put it recently:
“A period of wrenching volatility is inescapable. This happens periodically in financial markets, yet those very markets tend to produce wealth for people who are able to ride out this turbulence.
“It is important, as always, to make sure you have enough put aside for an emergency. Then assess your ability to withstand the impact of nasty headlines and unpleasant financial statements documenting market losses.”
(PPA note: We use the word “declines” to describe reductions in the value of your portfolio on monthly or quarterly statements. “Losses” only come when you’ve actually sold an investment for a lower price than you originally bought it.)
“Cheap, broadly diversified index funds that track the overall market are being hit hard right now, but I’m still putting money into them. Over the long run, that approach has led to prosperity.
“Count on more market craziness until the Fed’s struggle to beat inflation has been resolved. But if history is a guide, the odds are that you will do well if you can get through it.”
As always, please don’t hesitate to contact us with questions or comments about these and other financial topics.