Most investors view bonds as the safe part of their portfolio, but that hasn't been the case so far this year. In fact, the first four months of 2022 have been one of the worst periods for bonds in the past 40 years.
Why has that happened? While bonds are less volatile than stocks, rising interest rates are causing bond yields to increase. When yields rise, the price of a bond will drop.
Unfortunately, this scenario is now at work. Because interest rates were extremely low and credit spreads were tight at the beginning of the year, rising interest rates have made the low yields from existing bonds less attractive, driving prices down.
So, the question is, does it still make sense for risk-averse investors to hold and buy bonds? For several reasons, we think it does. Here’s why.
Stocks Are Much More Volatile
While the -5.9% return for bonds in 2022’s first quarter was the third worst quarter since 1976, that loss wouldn’t even crack the top 20 for biggest quarterly stock market losses. Stocks are much more volatile than bonds, so it makes sense for a conservative investor to own some bonds.
Rising Interest Rates Are Not Guaranteed
Federal Reserve survey data shows that forecasters have predicted higher interest rates over and over for many years. Up until recently, they’ve been wrong.
In addition, much of the Fed’s short-term rate increases are likely priced into the bond market, so it seems unrealistic that US rates would continue to rise on this trajectory. Interest rates are just as impossible to predict as anything else in investing; assuming rates will take a certain path is just another form of market timing.
Bonds’ Performance Will Eventually Improve
Bonds have a limited range of outcomes, and two future developments will continue to make them a good investment.
First, remember that when a bond matures, the investor receives the principal amount they originally invested. For example, an investor who bought a 10-year bond for $100 at 3 percent interest has watched the price of that bond drop as yields have increased. If investors now require a 4% yield on that same bond today, the price on the first bond would drop to $92.
But as the original 10-year bond matures – in effect, returning the principal amount to the investor – the $92 price will eventually rise back up to $100. At that point, those proceeds can also be reinvested at a higher rate – a much better starting point.
While rising rates can be uncomfortable in the short run, it is in the bond investor’s best interest over the long run. Rising rates are the only path to higher yields, so if investors want to be able to generate more income from bonds, it was going to have to happen at some point. The speed at which rates have climbed has no doubt made this a tough stretch, but looking ahead, bonds are now in a much better position than they were a few months ago, so conservative investors should stay the course.