2022 was a unique situation for retirees who were hedging their portfolios with bonds, since bonds serve as the "safer" investment that protects those in distribution mode from stock market volatility. Yet that year, the "safer" investments were down by more than 10%.

2022 was not just a bad year for bonds; it was the worst year for bonds since 1842. With a time frame that far back, many would argue it was the worst bond market ever, as there is no peace of mind in stating, "Well, actually, this is not the worst-case scenario, as bonds had a worse return 66 years before the first Ford Model T was shipped to a customer in 1908."

Context is important

This doesn't happen by accident or randomly. This was not a product of a credit crisis or market crash in the traditional sense, but rather a victim of the circumstance of interest rates rising faster than markets had priced in.

By the end of 2022, the returns of the following indices were:

• Dow Jones Industrial Average: -8.8%

• Nasdaq Composite: -33.1%

• S&P 500: -19.4%

• U.S. Investment Grade Bonds: -13%

Down markets are normal, and historically (for U.S. stocks) about 3 out of 10 years are negative. When people think of a horrible market, they often turn to 2008, where U.S. stocks were down about -37%. However, U.S. investment-grade bonds were up 5.2%.

Bonds did exactly what they were supposed to do in such a bad year: they offered a hedge, so to the extent you needed a distribution, you had the option to pull from bonds instead of selling stocks at such a large loss.

What made 2022 so different?

The one thing that was supposed to hedge was down as well. If this is normal, then what is the point of using a traditional 60/40 portfolio, or some semblance of that?

For over a decade before 2022, interest rates were at historic lows. The Federal Reserve pushed the federal funds rate to near zero in response to the 2008 financial crisis, and aside from a brief tightening cycle in 2017 to 2018, rates stayed low through the 2010s. When COVID hit in 2020, the Fed cut rates back to zero and launched a massive bond-buying program to keep credit flowing through the economy.

This meant bonds issued throughout this period, including 10-year and 30-year Treasuries, carried very low coupon rates, often between 1% and 2%. Investors accepted these low yields because there was no better alternative in a near-zero-rate world, and because inflation was tame, generally under 2% annually.

Bonds and Interest Rates

Before discussing the trigger that set off inflation, it is important to highlight a core bond mechanic and its relationship to interest rates. Bond prices and interest rates are inversely related: as rates rise, bond prices fall. An example: if you buy a bond paying 3% and, due to rates, can now get bonds paying 5%, who would want to purchase your bond, which pays less than what is currently available? Investors would much rather purchase bonds at the current 5% rate, which is what causes the value of your 3% bond to go down.

One of the catalysts I will focus on is fiscal and monetary stimulus. The federal government injected trillions of dollars into the economy for pandemic relief while keeping rates at zero. By the time the economy reopened, consumers had savings full of stimulus and unemployment money and began spending eagerly on goods rather than services. Demand far outpaced supply, driving prices even higher.

For much of 2021, the Fed was using the buzzword "transitory." They claimed this rising inflation was just transitory, and that supply chains would resolve, and prices would begin to fade on their own. By late 2021, the buzzword was put on the shelf; inflation was no longer transitory, and the Fed needed to start this fight against inflation far later than many economists thought it should.

The Fed had to begin raising rates and did so quickly. They raised the federal funds rate at 7 consecutive meetings that year. By the end of 2022, the federal funds rate went from near 0% to 4.25%-4.50%.

Gradually over time

There is a metaphor about boiling a frog that I am sure we are all aware of. If you want to boil a frog, you gradually increase the heat, since the frog will not notice, rather than placing it directly into boiling water. Moral and PETA violations aside, the metaphor stands true. People are less likely to respond to gradual harm over time, until it becomes catastrophic, and oftentimes, by the time it is noticed, it is too late.

This applies to rate changes as well. Markets can generally absorb gradual rate changes because they get priced in over time. 2022 did this on a very compressed timeline, and, in simple terms, turned the burner on high, and bond markets had to reprice an entire decade's worth of low-rate assumptions in just a matter of months.

The federal funds rate directly influences short-term rates, but it also ripples across the entire yield curve. As short-term rates rose, newly issued bonds across all maturities began offering coupons meaningfully higher to stay competitive. This left existing bonds, issued when rates were near zero, needing to fall in price so their fixed, lower coupons would produce a comparable yield to new issuance. The bigger and faster the rate increase, the bigger and faster the price adjustment on existing bonds.

Duration estimates a bond's sensitivity relative to changes in interest rates. Example: a bond with a duration of 5 would be expected to fall approximately 5% in price for every 1-percentage-point rise in rates.

Long-term and Short-term

Long-term Treasury funds, holding bonds with maturities of 20 years or more, saw declines of 25% to 30% or more, an extraordinary drawdown for an asset class typically associated with capital preservation. The broad Bloomberg US Aggregate Bond Index, which blends various maturities and bond types, still fell around 13%, its worst calendar-year performance since its inception in 1976. Short-term bonds and cash equivalents held up meaningfully better, since their prices are far less sensitive to rate changes, and they matured quickly into the new, higher-rate environment.

"Unprecedented" was a word used ad nauseam in 2020, but what happened in 2022 was truly unprecedented and came from a chain of events. While there is still risk, the Fed can learn from this scenario and ensure, through clearer, quicker communication, that we avoid something like this again.

At the advisor level, strategies such as laddering bond durations or using a barbell strategy help mitigate risk, as does incorporating alternative investments into a portion of the portfolio. If you have any questions about your current strategy, or are looking to build one tailored to your needs, our advisors at Whitaker-Myers Wealth Managers are happy to meet with you and ensure you understand the market context and how it impacts your portfolio.