After a Bad Year, Should You Still Own Bonds?

This year has been the worst year for bonds since the Great Depression. All major bond categories are down for the year, at a time when stock indices are also down. Even very short-term bonds, which historically have been very stable, are down. This has caused some fixed income investors to wonder "why hold bonds?"

It's rare for high quality fixed income investments to have negative total returns over a 12-month period. For example, since 1976, there have only been 65 instances out of 550 total where the broad fixed income index was down over a 12-month period. That's just shy of 12% of all instances. It's even more rare for both stocks and bonds to be down at the same time over a 12-month rolling period (a rolling 12-month return is the total return for the preceding 12-month period; rolling returns can be useful because they smooth past performance to account for multiple time periods, not just a single instance).

Historically, bonds have provided a buffer when stocks fell. Since 1976, there have only been thirteen 12-month periods, or 2.4% of the time, where both stock and bond returns were negative.

Zooming in on only the 12-month rolling periods where stocks have been negative further illustrates how much 2022 has been an anomaly. The gray bars in the chart below rank the 12-month rolling returns for the S&P 500 from the worst to the least bad, beginning in the 12-months ending in 1977 and ending in October 2022. The mostly green bars are the returns for bonds during that same 12-month period. The highlighted bars show the instances where stocks (red bars) are down, and bonds (yellow bars) are down in the same period.

There are a few things to highlight in the below chart. First, when stocks have fallen, bonds have usually posted positive returns, as evidenced by the number of green bars. Second, this past year has been an exception. The 12 months ending October 31, 2022, have been among the worst periods for equities and for bonds. By contrast, for the 12 months ending in February 2009, equities were down more than 44% but bonds delivered a positive 2% total return.

There's an old saying that "history doesn't repeat itself, but it often rhymes." While that can apply in many situations, we don't believe it applies to what's to come for bond returns. Returns have been historically weak this year for two primary reasons—starting yields were very low and the Federal Reserve's pace of rate hikes has been very rapid. Since March the Fed has increased the federal funds target rate five times, pushing it up from near zero to a range of 3% to 3.25%. It has been the fastest and most aggressive pace of tightening going back to the early 1980s. However, we believe that going forward the pace of rate hikes will slow and ultimately stop, which should limit the upside for longer-term bond yields (which move inversely to bond prices).

Now that yields have re-set at much higher levels, the blow from price declines should be cushioned by higher coupon income. Bond returns are mostly composed of a coupon return and changes in prices. Coupon returns are always positive and historically have provided a buffer from falling prices. Because yields were so low to start the year and rose very sharply, the coupon return wasn't large enough to offset the decline in prices, resulting in nearly the worst 12-month total return for the bond market since the 12-months ending in 1977.

It's not impossible for this year to repeat, but it's highly unlikely. As of the end of October 2022, the 12-month total return for the Bloomberg U.S. Aggregate Bond Index, which is a broad bond index, was down 15.7%. For the broad index to be down another 15.7%, the yield on the index would have to increase by nearly 4.6 percentage points, from roughly 5.0% to 9.6%. While a rise in yields of that magnitude is possible, we believe it's highly unlikely. There have only been six instances out of 550 since 1976 where yields rose more than four percentage points in a 12-month period. All those instances occurred in 1980 or 1981, when the Fed hiked the federal funds rates to as high as 20%.

One of the benefits of high-quality bonds is that historically, their returns have not fluctuated as much as equities have. This can help smooth diversified portfolio returns. For example, since 1976, the worst rolling 12-month total return for a portfolio of 30% bonds and 70% stocks was just over negative 30%. For a portfolio with a higher allocation to bonds, 70% in this case, the return over that same period was negative 12%. It's worth noting that the best returns for a portfolio that's weighted more toward bonds isn't as high as portfolio that's weighted more towards equities.

Portfolio volatility matters for both risk capacity and risk tolerance. Risk tolerance is simply an investor's emotional comfort with taking risk. In other words, how big of a drop in your portfolio will keep you up at night? Risk capacity is how much financial risk you can afford to take without it impacting your lifestyle. Risk capacity is especially important to consider when taking withdrawals from a portfolio.

For example, the chart below shows the impact to a hypothetical $500,000 portfolio that's distributing $20,000 per year adjusted for inflation for 30 years. In each case, the portfolio experiences an annual return of 6% for all but one year. In the year it doesn't earn 6%, it loses 20%. In the "big drop initially" case the 20% drop comes in the first year the portfolio is taking distributions, whereas in the "big drop late" case the 20% drop comes in the last year. The portfolio returns are the same, it's just the timing that's different (this is a concept also known as "sequence of returns" risk).

In the case of the portfolio that experienced a 20% decline initially, it would have run out of money after 27 years of withdrawals assuming no other adjustments. However, the portfolio that experienced the 20% decline late  would have ended with just shy of $400,000 after 30 years of withdrawals—a substantially different outcome, solely due to the timing of returns.

This matters because a portfolio with a greater allocation to bonds historically has been less volatile and less likely to experience large drops.

It's been a brutal year for fixed income, but that's not a reason to avoid bonds going forward. This year has been an anomaly and is unlikely to repeat, in our view. Going forward, returns should be better because starting yields are higher and it's unlikely that rates will continue to rise like they have. We suggest investors consider extending duration to take advantage of the move up in yields and stay up in credit quality by focusing mostly on higher-rated bonds.