Bonds are safe, right?

By Kevin Theissen

It may turn out that 2022 ends as one of the most volatile years for bonds in many years. The Bloomberg U.S. Aggregate Bond Index has been down nearly 10% this year. The downturn in the bond market has challenged conservative investors and a widely held belief that bonds are “safe” investments. The S&P 500 is down about the same but stock market corrections are not surprising while a correction in bonds is surprising to many.

It’s no secret that interest rates, inflation and conflict in Ukraine have spiked this year’s volatility. The Consumer Price Index increased to 8.5% in the last 12 months which is greatly above the Fed’s 2% target. As a result, the Fed will likely accelerate interest rate hikes. When rates move higher, borrowing becomes more expensive which helps slow growth in the economy and then will reduce inflation. This is on the heels of the Fed’s actions in response to Covid-19 when rates were reduced by 1.5%. This made borrowing cheaper with the hope of keeping business afloat.

For investors, this is an interesting environment. Bonds prices typically have a direct inverse relationship with interest rates. So, if you own a bond while interest rates rise, the price of the bond will likely decline.

This is not an issue if you plan to hold the bond until maturity. The price typically declines because new bonds that mature at the same time will pay a higher rate and therefore will be more attractive. If your bond pays less interest than a newly issued bond, then the price of your bond must drop to provide a similar yield to the new bond. This is not all bad news. If you hold on until your bonds mature you could reinvest in new bonds that have higher yields. The shift toward higher rates may be good news as it signals the artificially low rates associated with Covid may be over and bond portfolios could provide more yield. In the short term, it may seem difficult but the shift from extremely low rates may help investors over the long term.

Kevin Theissen is the owner and principal of HWC Financial in Ludlow.