Positioning Your Portfolio for 2023 After a Difficult Year for U.S. Bonds in 2022

The bond market suffered a significant meltdown in 2022. This was caused by a number of factors, including a rise in interest rates and a decrease in demand for bonds. This led to a sharp decline in bond prices, which caused many investors to lose money.

Bonds are often seen as the dull, safe option when it comes to investing. They have a history of helping to stabilize portfolios during stock market crashes. However, that relationship broke down last year, and bonds were anything but boring.

According to an analysis by Edward McQuarrie, a professor emeritus at Santa Clara University who studies historical investment returns, it was the worst-ever year on record for U.S. bond investors.

The implosion of the U.S. economy is largely a function of the Federal Reserve's aggressive interest rate hikes to fight inflation. Inflation peaked in June at its highest rate since the early 1980s, and was caused by a combination of pandemic-related shocks.

Inflation is bad news for bonds, McQuarrie said. When inflation goes up, bond prices go down, and vice versa.

Personal finance experts say that high inflation and rising interest rates make it important to know where to keep your cash. They also say that workers are still quitting at high rates, and that those who do usually get a big bump in pay. As for the best way to pay down high-interest debt, they recommend doing it as quickly as possible.

"The bond market in the United States is expected to be very weak in 2022," he said. "This is going to be one of the worst years in terms of bond market performance."

He said that the analysis focuses on "safe" bonds like U.S. Treasurys and investment-grade corporate bonds, and that this is true for both "nominal" and "real" returns (returns before and after accounting for inflation).

The Total Bond Index is a good example of an investment-grade bond index. This index tracks U.S. investment-grade bonds, which are corporate and government debt that credit-rating agencies deem to have a low risk of default.

The index lost more than 13% in 2022. This was its worst 12-month return since March 1980, when it lost 9.2% in nominal terms, McQuarrie said.

The 1972 index can give us an idea of how far back we can look using different bond barometers. Returns for bonds tend to get worse the longer the time horizon, or maturity.

Intermediate-term Treasury bonds lost 10.6% in 2022, the biggest decline on record for Treasurys. This is the biggest decline since 1926, when monthly Treasury data is a bit spotty.

The longest U.S. government bonds have a maturity of 30 years. Such long-dated bonds lost 39.2% in 2022, as measured by an index tracking long-term zero-coupon bonds.

According to McQuarrie, that's a record low dating back to 1754. The second-worst showing was during the Napoleonic War era, when long bonds lost 19% in 1803. McQuarrie said that the analysis uses bonds issued by Great Britain as a barometer before 1918, when they were arguably safer than those issued by the United States.

"The bond market experienced a major shift last year, and we knew this was a possibility," said Charlie Fitzgerald III, a certified financial planner from Orlando, Florida. "Now, we need to be prepared for the potential consequences." "It was really tough to see it play out."

The future is impossible to predict, but many financial advisors and investment experts think bonds will not perform as poorly in 2023 as they have in the past.

Advisors say that while returns may not necessarily become positive, bonds are likely to reclaim their role as a portfolio stabilizer and diversifier compared to stocks.

"Bonds and stocks tend to behave differently - if stocks go down, they may not move much at all," said Philip Chao, chief investment officer at Experiential Wealth, based in Cabin John, Maryland.

Interest rates in 2022 started out very low, as they had been for most of the time since the Great Recession.

The U.S. Federal Reserve lowered borrowing costs to near zero at the beginning of the pandemic to help support the economy.

The central bank reversed course starting in March, raising its benchmark interest rate seven times last year. This was the most aggressive policy move since the early 1980s, and it has resulted in a 4.25% to 4.5% interest rate.

The implications of this were significant for bonds.

Bond prices and interest rates have an inverse relationship - when interest rates go up, bond prices go down. This is because when new bonds are issued at higher interest rates, the value of existing bonds goes down. This makes existing bonds less attractive to investors, and causes the price of the bond to fall.

Bond yields in the latter half of 2022 were among their lowest in at least 150 years, making bonds some of the most expensive assets in historical terms, according to John Rekenthaler, vice president of research at Morningstar.

Bond fund managers who had bought expensive bonds ultimately sold them at a loss when inflation began to surface, he said.

Rekenthaler wrote that a more dangerous combination for bond prices can scarcely be imagined.

Bonds with longer maturity dates were especially affected. The maturity date can be thought of as the bond's term or holding period.

Bond funds that hold longer-dated notes usually have a longer "duration." Duration is a way of measuring a bond's sensitivity to interest rates, and it is affected by maturity, among other things.

Here's a simple way to see how it works. For example, let's say an intermediate-term bond fund has a duration of five years. In this case, we would expect bond prices to fall by 5 percentage points for every 1-point increase in interest rates. The anticipated decline would be 10 points for a fund with a 10-year duration, 15 points for a fund with a 15-year duration, and so on.

The losses suffered by long-dated bonds in 2022 can be explained by the significant increase in interest rates that year. Rates rose by approximately 4 percentage points, which made bonds with longer terms much less attractive to investors.

This year seems to be different, though.

The Federal Reserve is expected to keep raising interest rates, but the increases are not expected to be as dramatic or rapid as in the past, which means the impact on bonds will be more muted, advisors said.

Lee Baker, an Atlanta-based CFP and president of Apex Financial Services, believes that the Federal Reserve will not raise interest rates as quickly or as high as predicted in 2022. "When you go from 0% to 4%, that's crushing," Baker said.

He added that there is no way they will go to 8%.In December, Fed officials projected that they would raise interest rates as high as 5.1% in 2023. However, that forecast could change. According to Chao, it seems that most of the losses in the fixed income market are behind us.

In addition, bonds and other types of "fixed income" are entering the year with much stronger returns for investors than they did in 2021. This is good news for those looking to invest in these types of assets.

CFP Cathy Curtis, founder of Curtis Financial Planning, based in Oakland, California, said that this year is a whole new scenario.

Fitzgerald said that, despite the big picture for 2023, bonds should not be abandoned given their performance last year. He added that bonds still have an important role in a diversified portfolio.

Advisors say that the traditional 60/40 portfolio split between stocks and bonds is likely to return. This means that bonds will likely provide stability when stocks fall.

Over the past decade or so, low bond yields have led many investors to raise their stock allocations in order to achieve their target portfolio returns. This has resulted in an overall stock-bond allocation of 70/30, as opposed to the traditional 60/40 split. According to Baker, this trend is likely to continue in the future.

According to Baker, in 2023 it may make sense to reduce stock exposure to the 60/40 range again. This could achieve the same target returns as before, but with reduced investment risk.

Some advisors recommend holding more short- and intermediate-term bonds to minimize interest-rate risk. The extent to which investors do this depends on their timeline for their funds.

For example, an investor saving to buy a house in the next year might park some money in a certificate of deposit or U.S. Treasury bond with a six-, nine- or 12-month term. High-yield online savings accounts or money market accounts are also good options for short-term savings goals, advisors said.

Curtis said that cash alternatives are generally paying about 3% to 5% right now.

"I can invest my clients' money to get decent returns safely," she said.

Looking ahead, it's not as wise to be overweight in short-term bonds, Curtis said. It's a good time to start investing in more typical bond portfolios with an intermediate-term duration, of, say, six to eight years rather than one to five years, given that inflation and rate hikes appear to be easing.

Curtis suggested that the average investor could consider a total bond fund like the iShares Core U.S. Aggregate Bond fund (AGG). As of Jan. 4, the fund had a duration of 6.35 years. Curtis added that investors in high tax brackets should buy a total bond fund in a retirement account instead of a taxable account.