First Quarter Review and Year in Review 2022 Part 2: Bonds
First Quarter 2023 Review
Overall, stocks and bonds provided solid returns in Q1 2023. Globally, stocks returned over 7%.² The US bond market was up nearly 3%.³ Unlike last year, however, large and growth stocks fared better than small and value companies: the US S&P 500, for example, rose 7.5% while domestic small-value stocks lost roughly 0.5%.⁴ The panic at Silicon Valley Bank impacted small-value returns as investors looked askance at regional banks and, as a group, those banks are overrepresented in small-value indices.
The Bond Bear Market of 2022
Last year was a dreadful year in the bond markets. As noted in a recent article on Morningstar.com: “By historical standards, bonds were a debacle in 2022. Instead of holding up as stocks fell, almost every type of bond—from government to junk—posted double-digit losses.”⁵
Indeed, the aggregate US bond market lost about 13% and international bonds went down roughly 10%.⁶ The US bond returns represent the worst year since at least 1976, the first year of the index.⁷ Bond investors who had not faced a down market in bonds likely realized the difference between “low risk” and “no risk.”
Below we’ll briefly explain why most bonds went down last year, explain our approach to bond investing, and examine why clients expecting double-digit bond losses might find a relatively pleasant surprise in their year-end statements.
Why did bonds go down in 2022?
Bonds went down largely because the US Federal Reserve (the “Fed”) raised interest rates. Other things equal, when the Fed (or any central bank) raises rates, bond prices fall. For example, let’s assume today we buy a bond that matures in one year and pays 3% interest. The next day, however, the Fed raises rates 1%. This means that investors can now buy a one-year bond with 4% interest. If we try to sell our 3% bond now, no one would pay full price because of higher yielding options available. Thus, we would have to lower the price of our bond if we wanted to sell. That’s why rising rates likely means lower bond prices.
Why Did the Fed Raise Interest Rates in 2022?
The Fed has what is known as a “dual mandate”: it seeks to keep both unemployment and inflation low. These two goals, however, can be in tension. Very low unemployment can mean an overheating economy, and an overheating economy can mean high inflation. Conversely, very low inflation can mean a stagnating economy or a recession and, thus, higher unemployment.
As you may know, last year the United States faced very high and increasing inflation. The inflation and low unemployment strongly suggested an economy in danger of overheating. The Fed raised rates to “cool” things off and help stall inflation. It appears, thus far, that the Fed was successful as most indicators show slowing inflation.⁸
How Does Wealth Architects View Fixed Income?
We believe fixed income has two roles in a diversified portfolio. The first role is investment return. Bonds provide income and may also provide a capital return. Over time, we do expect bonds to help us outpace inflation, albeit not as much as equities.
We also believe fixed income should provide stability in our investment portfolios. Overall, bonds tend to be less volatile than stocks. But there is a great range within fixed income: the longer the bond and the lower the bond rating, the higher the risk and return. To our eye, long-term, high-yield bonds act very similarly to equities and may not dampen portfolio volatility in times of stress. Therefore, we tend to recommend bonds that are shorter and higher quality than the overall market. Although short and high-quality bonds do have lower yields, we expect them to hold up better when fixed-income markets swoon.
Did our expectations hold true last year? Yes. High-yield bonds lost about 13% last year compared to a loss of about 9.5% for similar-maturity US treasuries.⁹ More impactful, short bonds went down less than 4% last year.¹⁰
As with our review of equities, we can’t make general comments regarding client investment returns because each portfolio is unique. But we believe that our tilts toward short and high-quality bonds provided ballast during a very turbulent year. Again, as with equities, we suspect clients fearing double-digit fixed-income losses last year will be pleasantly surprised.
¹ When is a Bear Market Not a Bear Market, Wealth Architects 2023.
² Global stocks represented by the MSCI ACWI Index. All investment returns from Morningstar unless otherwise noted. Past performance is no guarantee of future results.
³ US bond market represented by the Bloomberg Barlcays US Aggregate Bond Index.
⁴ US small-value companies represented by the Russell 2000 Value Index.
⁵ Is it Time to Pick Up the Pieces After Last Year’s Bond Market Storm?, Eric Jacobson, Morningstar.com, January 30, 2023.
⁶ US stocks represented by the Bloomberg US Aggregate Bond Index and foreign stocks represented by the Bloomberg Global Aggregate ex USD 10% Issuer Capped (Hedged) Index. Source: iShares.com
⁷ Source: JP Morgan.
⁸ See, e.g., Inflation Fell Sharply in March, Wayne Duggan, Forbes Advisor, April 12, 2023.
⁹ Comparing the Bloomberg US Corporate High Yield Index and the IDC US Treasury 3-7 Year Index.
¹⁰ Short bonds represented by the Bloomberg Barclays US Govt/Credit 1-3 Index.
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The information provided in this commentary is intended to be informative and not intended to be advice relative to any investment or portfolio offered through Wealth Architects. The views expressed in this commentary reflect the opinion of the author based on data available as of the date this article [essay] was written and is subject to change without notice. This commentary is not a complete analysis of any sector, industry or security. Individual investors should consult with their financial advisor before implementing changes in their portfolio based on opinions expressed. The information provided in this commentary is not a solicitation for the investment management or other services offered by Wealth Architects. References incorporated into the report [essay] from third party sources are as of the date specified and are believed to be reliable. Wealth Architects is not responsible for errors in the third party data.