The bond market saw its worst year on record in 2022, with the Barclay’s U.S. Aggregate Bond Index falling 13%. What caused this historic downturn and what does it mean for you?
The culprit was inflation and the aggressive response of the Federal Reserve, the Bank of England, and the European Central Bank to it. In an effort to get a cap on inflation, these central banks raised interest rates to their highest levels since the 1980s. This meant that holders of five, 10-year, or longer dated bonds were seeing the value of their bonds drop significantly.
Inflation expectations are key to understanding the bond market. The Cleveland Federal Reserve Bank’s Center for Inflation Research currently estimates that US inflation over the next 10 years will be 2.27% per year.
Bonds are generally seen as a reliable investment, but this does not mean that investing solely in bonds is wise. Riskier bonds may have price volatility, but they also yield higher rates of interest than conservative, less-risky bonds. Government bonds are generally a safer investment than corporate bonds, as the government can print money and has a stable economy to support the bond. Corporate bonds, on the other hand, rely on the cash flow of the company that issued them.
The recent January Consumer Price Index (CPI) data suggests that inflation may remain stubbornly high. The CPI was up 6.4% year-over-year, and 0.5% monthly, its fastest pace since October. This could mean further rate hikes from the Federal Reserve, leading to more pain for bond holders.
It is important to remember that while bonds are less volatile than other investments and tend to outperform equities in times of economic hardship, they are not a rock-solid investment. When investing in bonds, it is wise to focus on higher-rated bonds, and not high-yield bonds, which usually have lower rates and greater risk.
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