After a year that many investors will want to forget, 2022 came to an end a few weeks ago with major stock and bond markets seeing losses unlike any in years. In fact, the bond market saw losses it had never seen before—down 13% for the core bond index, which is the Bloomberg Aggregate Bond Index, and that is 10% worse than the previous worst year ever for bonds. So after years of providing safe, and frankly boring returns, 2022 will go down as the worst year ever for core bonds. In this edition of the LPL Street View, Fixed Income strategist Lawrence Gillum asks the question: can bonds be boring again?

For years, conservative investors have looked to the core bond market—U.S. Treasuries, high-quality corporate and muni bonds and agency mortgage-backed securities in particular—to build out their investment portfolios. Conservative portfolios typically had anywhere between 60–80, to even 100%, of assets allocated to bonds. And for years, bonds did exactly what they were supposed to do: provide income, diversify equity risks, and provide liquidity to portfolios. And through the years, bonds were largely considered to be low risk and, in fact, boring investments. That all changed in 2022. With inflationary pressures last seen in the 70s and 80s, the Federal Reserve (Fed) embarked on the most aggressive rate hiking campaign in decades, and bonds turned out be neither safe nor boring.

So what happened? As is now known, the Fed waited too long to address the persistently high consumer price increases early last year, but then had to play catch up by front loading interest rate hikes unlike any seen in decades. The Fed raised interest rates in seven consecutive meetings to take the fed funds rate from near zero to 4.5%. During that rate hiking campaign, the Fed raised rates by ¾ of a percent an unprecedented four times in a row, before slowing last month to a ½ percent hike. Over the past 40 years, the Fed has only raised the fed funds rate by ¾ percent five times, with four of them coming last year. Truly historic. 

And because of that aggressive rate hiking campaign that took place largely in one calendar year,  Treasury yields increased the most in one calendar year on record. The chart here shows the change in the 10-year Treasury yield on a calendar basis and the 2.4% increase in yield last year was more than any calendar year period on record; even during the 1970s and ‘80s when interest rates and inflation were significantly higher than today.

So where does one go from here? It is not expected for the Fed to continue to raise rates at the historically aggressive levels it did last year, and it’s certainly not expected for Treasury yields to rise by the historic levels like they did last year either. After last year’s bond market losses, we think the damage has been done. To get a repeat of the negative returns seen out of the core bond market, Treasury yields would need to increase by around 3.5%, which would once again be the most on record and not something we think is probable at this point.

We think the Fed will raise short term interest rates another ½ percent or so, but that’s it. And that slowdown in rate hikes should take pressure off the bond market, like it has historically. Bonds tend to do well after the Fed stops raising rates.

Benjamin Franklin is known for saying “out of adversity comes opportunity”. And that is certainly true within the fixed income markets. 2022 was a year of adversity, no question. But that adversity brought with it higher starting yields, yields not seen in over a decade. And perhaps the best opportunity to invest in core bonds in over a decade. While we can’t guarantee there isn’t more volatility in the near term, we do think the bond market can get back to its traditional role of providing income, stability, and liquidity to portfolios.  And frankly be boring again.

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