A Historic Meltdown 

Clients who hold fixed income securities have seen their investments take a substantial hit this year. So far, the majority of major U.S. bond indices are down between 6% and 15% (see table below) through July 2022, the worst performance on record for many, despite a rally last month. 

The drivers of the bond market’s collapse are clearly spelled out in today’s headlines. Over the last several months, inflation has reached a 40-year high, fueled by post-lockdown factors that include pent-up consumer demand, spiking oil prices, and global supply chain disruptions further exacerbated by the war in Ukraine.

Unprecedented Challenges in the Bond Market

After first underestimating the tenacity of today’s inflationary forces, the Federal Reserve is playing catch-up, raising the fed funds rate four times already this year, including increases of 50 basis points in May and 75 in June and July. In addition, July’s stronger-than-expected inflation data makes it likely rates will continue to climb. When interest rates rise, bond prices fall. This simple fact explains most of the bond market’s volatility so far in 2022.

For investors, bonds have traditionally provided “ballast” to portfolios. Their ability to generate income and (in normal times) low correlation to stocks made bonds a leading choice as a diversifier and a way to manage risk. Though the major bond indices fell significantly this year, the U.S. stock market, as measured by the S&P 500® Index, has fallen farther, reaching declines as low as -24%. Bonds are still acting as a buffer against the worst of volatility despite their historically poor performance.

The Power of Diversification

Diversified Portfolio and S&P 500 Index Returns

Considerations for Clients

Market declines like those experienced in the first half of 2022 can be unnerving, tempting investors to make reactive decisions that may not be in line with their long-term goals. The chart above makes an important point in this regard. If you are invested in all equities, you are more likely to panic and sell at the wrong time (at or near market bottom) compared to the lessened volatility of a diversified portfolio that tends to keep investors in their allocation, helping them stay the course. That is the beauty of diversification. By mixing asset classes that do not move in tandem, clients can potentially achieve greater returns with less risk over time. 

Changes in market cycles, along with periods of higher volatility, and a shorter-term positive correlation across asset classes such as stocks and bonds, which we are experiencing today, are a normal part of investing, and planning for them should be part of client conversations. Though both stocks and bonds are down in 2022, the wisdom of using diversification as a basic risk management strategy has not changed. If anything, the volatility of the markets this year underscores the need to manage risk, and diversification among asset classes, including bonds, remains one of the most effective methods to do that. Bonds continue to serve the role of providing a stabilizing ballast to portfolios in the form of steady income (now at higher yields) and returns that, in times of greater normalcy, tend to move independently of the stock market.