So far in 2022, with inflation soaring, bonds have lost 10%, one of the worst returns in US history. On Wednesday, the Federal Reserve raised interest rates by 0.5 percentage point , the largest increase in 22 years.
However, just as your body begins to heal from injury before you can feel any improvement, the worst for bond investors may be coming to an end. Those dumping bonds now could be making a mistake by selling low after buying high.
Let’s start by putting the pain in historical perspective.
The US bond market has had positive returns, before inflation, in all but four years since 1976. Even in 1994, when the Federal Reserve raised interest rates six times by a total of 2.5 points Percentage-wise, bonds lost just 3% overall.
Hardly ever has the US bond market lost as much money as in the first four months of 2022, according to Edward McQuarrie, an emeritus professor of business at Santa Clara University who studies asset returns over the years. centuries.
Long-term Treasuries lost more than 18% this year through April 30. That tops the previous record, a 17% loss in the 12 months ending March 1980, says McQuarrie. The broad bond market has performed worse so far in 2022, he says, than in any full year since 1792 except one. That was in 1842, when a deep depression bottomed out.
It’s worth noting that, adjusted for inflation, at least nine prior periods have been worse, says Bryan Taylor, chief economist at Global Financial Data, a research firm in San Juan Capistrano, California.
Inflation is like kryptonite for bonds, whose interest payments are fixed and therefore cannot grow to keep pace with increases in the cost of living. Until recently, inflation seemed like a problem from the distant past, when it often plagued bond investors.
For most of the four decades since 1981, interest rates have been falling and bond prices rising, creating a tailwind of capital gains for fixed-income investors. Not only did he earn interest on his bonds, but he also pocketed additional profits as they increased in value.
For some extended periods, like the 20 years ending in March 2020, bonds returned even higher than stocks, without any of their hair-raising losses.
Those glory years are gone.
“I think the long downward trend in interest rates has finally come to an end,” says Mr. Taylor. “People have been wrong about the direction of rates for 40 years, but I have to think at this point they might finally be right.”
The prospect of losing money as rates rise seems to be scaring a lot of people. After pouring $592 billion into bond funds last year, investors have withdrawn $104 billion so far in 2022, according to the Investment Company Institute.
But a gradual increase in rates is not bad for bond investors, as long as inflation is under control.
Make no mistake: Investing in bonds is a leap of faith that the Federal Reserve can control inflation. And that, as US Treasury Secretary Janet Yellen has said, “will take skill and also good luck.”
However, if the Fed controls inflation, bond investors should be fine, and they should do better over time, since they reinvest their income instead of taking it as cash.
In the long run, the total return on bonds depends much more on your income than on changes in price. Since 1976, just over 90% of the US bond market’s average annual return has come from interest and reinvestment, according to Loomis, Sayles & Co., an investment manager in Boston.
Thanks to the recent drop in prices, the aggregate US bond market yield of around 3.6% has doubled since December 31.
People always chase the past with their money. Investors added more than $445 billion to bond funds in 2020, largely because previous returns were so strong. But by the end of that year, yields on the US bond market had fallen to just over 1%, meaning future yields would be weak.
Investors were too excited then. Perhaps now they are too pessimistic.
The single best predictor of future bond yields, before inflation, is their yield to maturity. As prices fall, yields rise, so the recent decline in bonds has increased their expected returns.
“With these early returns now, you have more protection against rising rates,” says Lauren Wagandt, co-manager of the T. Rowe Price Corporate Income Fund. “And we’re starting to see some value emerge.”
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Corporate bond index yields, he says, are nearing their highest levels in at least 11 years.
The recent rise in yields also means that shorter-dated US Treasuries are likely to be more effective buffers against future declines in equities.
If your recent losses make you want to redeem bonds, remember why you own them. Bonuses are not meant to make you rich; they keep you from becoming poor while paying you some income along the way.
“It’s important not to get too excited about the recent returns we’ve seen,” says Ms. Wagandt. “Now there is more revenue and more value.”
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