So far in 2022, as inflation rages, 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, its strongest rise in 22 years.
But just as your body begins to heal from injury before you can feel any improvement, the worst may already be over for bond investors. Those dumping bonds now may be making a mistake selling low after buying high.
Let’s start by putting the pain in historical perspective.
The US bond market has seen positive returns, pre-inflation, in nearly four years since 1976. Even in 1994, when the Federal Reserve raised interest rates six times to a total of 2.5 percentage points, bonds lost just 3% in total.
Hardly ever has the U.S. bond market lost as much money as it did in the first four months of 2022, according to Edward McQuarrie, a business professor emeritus at Santa Clara University who has studied asset returns over the centuries.
Long-term government bonds lost more than 18% this year through April 30. That beats the previous record, a loss of 17% in the 12 months ended March 1980, says Mr McQuarrie. The broad bond market has done worse so far in 2022, he says, than in any full year since 1792, except one. That was all the way back to 1842, when a deep depression was nearing its nadir.
It’s worth noting that, adjusted for inflation, at least nine past periods were worse, said 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 thus cannot grow with the rise in the cost of living. Until recently, inflation seemed like a problem of the distant past, when it often plagued bond investors.
For most of the four decades since 1981, interest rates have fallen and bond prices have risen, creating a tailwind of capital gains for fixed income investors. Not only did you earn interest on your bonds, but you also made extra profit as they rose in value.
Over several long periods, such as the 20 years ending in March 2020, bonds have outperformed equities, without their heart-pounding losses.
Those glory years are over.
“I think the long downward trend in interest rates has finally come to an end,” Taylor said. “For 40 years people have been wrong about the direction of the rates, but I have to think they are finally right on this point.”
The prospect of losing money if interest rates rise seems to scare many people. After putting $592 billion into bond funds last year, investors have pulled out $104 billion so far in 2022, according to the Investment Company Institute.
But a gradual rise in interest rates isn’t bad for bond investors, as long as inflation stays under control.
Make no mistake: investing in bonds is an act of confidence that the Fed can tame inflation. And that, as US Treasury Secretary Janet Yellen has said, “requires skill and a lot of luck.”
However, if the Fed is keeping inflation in check, bond investors should be okay — and should do better over time if they reinvest their income instead of taking it as cash.
In the long run, the total return of bonds depends much more on their income than on price changes. According to Loomis, Sayles & Co., an investment manager in Boston, since 1976, just over 90% of the average annual return of the U.S. bond market has come from interest and its reinvestment.
Thanks to the recent fall in prices, the yield on the overall US bond market, at about 3.6%, has doubled since December 31.
People are always chasing the past with their money. Investors added more than $445 billion to bond funds in 2020, largely because past returns have been so strong. But by the end of that year, yields on the US bond market had fallen to just over 1%, meaning future yields were bound to be weak.
Investors were too enthusiastic at the time. Maybe they are too pessimistic now.
The single best predictor of the future yield of bonds, before inflation, is their yield to maturity. As prices fall, yields rise, so the recent flight into bonds has boosted their expected returns.
“With these starting yields, you now have more cushioning to weather rising interest rates,” said Lauren Wagandt, co-manager of T. Rowe Price Corporate Income Fund. “And we’re starting to see value emerge.”
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Corporate bond index returns, she says, are hitting their highest level in at least 11 years.
The recent rise in yields also means that short-dated US Treasuries are likely to provide a more effective buffer against future declines in equities.
If your recent losses make you feel like you need to save bonds, remember why you own them. Bonds are not meant to make you rich; they make sure you don’t get poor while paying you some income along the way.
“It’s important not to get too emotional about the recent return we’ve seen,” said Ms Wagandt. “There is now more income and more value.”
write to Jason Zweig at [email protected]
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