The first half of 2022 came to an end last week and some fixed income investors that are just now opening their statements are likely going to be shocked to see the historic drawdowns experienced during the first six months of the year. In this edition of the LPL Street View, Fixed Income Strategist Lawrence Gillum reviews the first half of 2022 and explains why we think these historically bad returns may be behind us and why we think now is not the time to abandon your core bond allocation.

The first half of the investing year came ended last week, and it was the worst start to the year ever for core bonds by a wide margin. The Bloomberg Aggregate index, which is the main core bond index for fixed income, was down over 10% during the first six months of the year due to changing expectations of a more aggressive Federal Reserve. At the beginning of 2022, markets were only expecting one or two short-term interest rate hikes by Fed this year, with most of the hikes expected to come in 2023. However, markets have aggressively re-priced the number of expected Fed rate hikes and now expect as many as 11 this year. As such, the yield on the 10-year Treasury security has doubled this year after increasing around 100 basis points (1.00%) off its lows in 2020. The 260 basis point move higher that has already taken place this cycle is the biggest move higher in yields since 1994, when rates moved higher by 280 basis points—and that was at the end of the rate hiking cycle. So, with as many rate hikes already priced in at this point, we do think the worst is behind us.

Now it’s also important to remember that the negative returns we’ve seen this year is just price volatility and not permanent impairment of capital unless you sell. Bonds are unique in their structures in that not only are they financial instruments, but they’re also financial obligations. So borrowers still have to pay periodic coupons and make principal payments at or above par, regardless of what interest rates do in the interim. And that doesn’t change whether you own an individual bond, a separate account, laddered portfolio, ETF, fund etc. Those financial obligations don’t change regardless of where you own bonds.

This means interest rates don’t have to do anything either for fixed income markets to start to recover- the average price of a bond within the Aggregate bond index is less than 93 cents on the dollar. And that isn’t just the riskier debt in the index; U.S. Treasuries are trading at the same price and at deep discounts to par. And does anyone really think the US isn’t going to pay back its debt at par?

While we can’t know for sure if the worst is truly behind us. We can say that the prospects for future returns within fixed income markets are the best they’ve been in over a decade. Remember, because bonds are financial obligations that mature at a certain date in the future, they pay contractually obligated coupons, and they mature at par. As a result, we have a fairly reliable way to measure future returns- and that’s starting yields. And starting yields on most fixed income asset classes are hovering around the highest yields we’ve seen in over a decade. Since starting yield levels are the best predictor of future returns, with yields already increasing a lot this year, future returns look more attractive than they have in years. With interest rates so low over the past few years, the back up in yields that we’ve already experienced this year could be an attractive opportunity for income-oriented investors. And while we can’t guarantee that interest rates won’t go higher, at current yields, the risk/reward for owning fixed income has improved, in our opinion. So, as bad as it’s been this year within the fixed income markets, we do think the worst is likely behind us and don’t expect these historically bad returns to continue. 

 

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This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth in the podcast may not develop as predicted and are subject to change.

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All index data is from FactSet.

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This Research material was prepared by LPL Financial, LLC. 

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