BONDS ARE ON PACE to have their worst year on record. To be sure, once interest rates stop rising—perhaps early next year—they may win back their place as a worthwhile investment for retired investors. But right now, that feels like wishful thinking.
As the Federal Reserve has hastily raised short-term interest rates in big steps to fight inflation, bond prices have fallen down the cellar stairs. Bloomberg’s broad U.S. aggregate bond index is down 16% in 2022. It’s the worst year for U.S. bonds since reliable recordkeeping began in 1926.
Bond prices fall when interest rates rise because bonds issued earlier—which pay lower rates—get discounted until their return equals the currently available yield on new bonds. No less an authority than Vanguard Group declared the six months through June 2022 the worst half-year for bonds “since either before the Civil War or George Washington was president.” If you’re wondering, the Civil War began in 1861 and Washington’s second term as president ended in 1797.
Bonds are supposed to provide a counterweight to stocks and act as a stabilizing force during bear markets. That hasn’t happened this year. Nothing’s worked.
Now for the better news: Bonds could rise from the ashes and make a valuable contribution once again to a retiree’s portfolio. The 10-year Treasury note yielded more than 4.2% in late October, its highest rate in 15 years, though that remains below the current U.S. annual inflation rate of 8.2%.
Still, higher bond yields could signal the end of TINA—the mantra that there’s no alternative to stocks. Since 2010, many investors who wanted income turned to dividend-paying stocks because bond yields were hovering near zero. Now, the yields on super-safe Treasurys can compete with utility stocks and easily outpace the dividend yield on most other shares. The S&P 500’s dividend yield is currently 1.7%.
I was taught there were three main asset classes: stocks, bonds and cash. The one to avoid when investing for retirement was cash because its returns were too scant. I broke this commandment when I retired in 2020. I sold bonds and stocked up on cash—not rustling paper cash, but certificates of deposit and other investments that promised stability of principal.
At the time, the 10-year Treasury yielded less than 1%, so I wasn’t missing out on income. Interest rates would have to rise someday, I reasoned, so bonds had nowhere to go but down. In the meantime, most of my cash accounts—which also yielded only 1% or 2%—were at least insured against loss by the Federal Deposit Insurance Corporation.
But now my cash is losing lots of ground to inflation. “Inflation will likely linger at an abnormal level for at least another season, which will keep the markets on edge,” Vanguard concluded in its third-quarter bond analysis.
What to do? At some point, I should switch from cash back to investment-grade bonds, but perhaps not just yet. The Federal Reserve is expected to continue raising short-term interest rates for a while longer, and that could send bond prices down again. There’s talk that the Fed will slow its campaign of interest rate increases next year, at which point bonds may stabilize.
At that juncture, bonds could win back their place in retirees’ portfolios. We could bank on bonds’ predictable stream of income, plus bond prices are historically less volatile than stocks. More income with less risk sounds promising.
What if inflation stays stubbornly high? That could dampen bonds’ comeback. Still, it’s worth remembering that investments often perform their best after they’ve been through hell—and when they’re most despised by investors.