The Role of Bonds in 2022

Kevin T. Cooper, CFA

VICE PRESIDENT | HEAD OF INVESTMENT RESEARCH

Bonds have traditionally performed the role of ballast to portfolios. Do they still?

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

Source: Bespoke Investment Group. Data as of July 31, 2022.

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
Source: Barclays, FactSet, Standard & Poor’s. As of June 30, 2022. Data date range is January 1999-Jun 2022. Bear Market defined as peak-to-trough decline of at least 20 percent. Standard Deviation (Std. Dev.): A measure of risk; it calculates the variability of returns by comparing the Fund’s return in each period with the average Fund return across all periods. Past performance is no guarantee of future results.

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. 

Past performance is not a guarantee of future results. The views expressed are not intended as a forecast or guarantee of future results, and are subject to change without notice. Any sectors, industries, or securities discussed should not be perceived as investment recommendations. There is no guarantee that any investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for a long term, especially during periods of downturns in the market.

 

Click here to view Index Definitions.

 

Diversification does not guarantee a profit or protect from loss in a declining market.

 

Diversified Portfolio Allocation: Investment Grade Bonds (IG Bonds): 32%, Municipals (Munis): 5%, U.S. High Yield Bonds (US HYB): 5%, U.S. Large Cap Equity: (US LC): 23%, U.S. Small Cap Equity (US SC): 10%, Foreign Developed Equity (For Dev): 10%, International Small Cap (Intl SC): 5%, Emerging Markets (EM): 5%, U.S. Real Estate (REITs): 5%. Alternatives are 5% of this allocation in most other representations of the diversified portfolio on this webpage. However, daily data is not available for the HFRI Index, so it is omitted from this chart.

 

The indices are unmanaged, are not available for investment, and do not incur expenses.

 

Basis point is equal to .01%

 

The S&P 500® Index is a capitalization-weighted index of 500 stocks. The S&P 500 Index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

 

© Copyright 2022 AMG Funds LLC. All rights reserved.

WRITTEN BY

Kevin T. Cooper, CFA

VICE PRESIDENT | HEAD OF INVESTMENT RESEARCH

PUBLISHED: August 12th, 2022
4 Min Read

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