Nowhere to Hide for Investors (But Don’t Bail on Bonds)

The April jobs report was solid, but don’t tell that to investors, more on them shortly. The economy added 428,000 jobs, for a total of over 6.6 million over the past year. Economist Joel Naroff notes that “the total number of jobs is now just 1.36 million below where it was at the peak in February 2020. The gains were widespread, with over 71 percent of the private sector industries posting increases.”

With job openings at an all-time high of 11.5 million as of March, workers still have leverage, wages were up 5.5 percent from a year ago, though that lags the overall inflation rate of 8.5 percent. The unemployment rate remained at 3.6 percent, just above the 50-year low, but the labor force shrank by 363,000, nudging the participation rate down to 62.2 percent from 62.4 percent (it was 63.4 percent pre-COVID).

The employment situation underscores that the Federal Reserve still has plenty of work to do. There is no sign of a slowdown in the economy, from the perspective of jobs, therefore, it is likely that after the first half-point rate hike in more than two decades, the central bank will probably raise rates by another half of a point at the June meeting. 

On the day that the Federal Reserve raised interest rates by a half of a percentage point, stocks shot up by about 3 percent, ostensibly because Fed Chair Jerome Powell said that the central bank was not (as previously feared) actively considering a 0.75 percent hike. A mere 12 hours later, the party was over, as investors worried that the Fed would not be able to thread the needle of increasing rates, without throwing the economy into a recession. It’s like the central bank is driving a speeding car and tapping on the brakes, to slow it down. If they don’t get it right, the car (the U.S. economy) could veer off the road and land in a recession ditch.

On top of the Fed’s monetary policy balancing act, there are also the big unknowns of the war in Ukraine, supply chain clogs, and the ability of companies to produce earnings in the future. All of these concerns conspired to push down stocks on the week, especially technology and growth companies.

In the past, when investors endured volatile weeks in the stock market, they would soothe their frayed nerves by focusing on their bond positions. Well, what happens when the so-called “safe” part of your portfolio loses value? That’s the conundrum that diversified investors are facing, as they confront this year’s drop in bond prices. The 2022 bond market rout is unrecognizable to many. Before you bail on your bonds, let’s talk about how to think about the current situation.

First, an overview. A bond purchase is essentially a loan to an entity, which can be a government, a state, a municipality, or a company. The loan is established for a predetermined period (30 days to 30 years), at a fixed rate of interest (hence the asset class’s official name, “fixed income”.) Borrowers are on the hook for interest payments, either at periodic intervals (usually every six months), or at the end of the agreement, when they repay the obligation in full.

Because bonds deliver a consistent stream of income, investors have seen them as an integral part of a diversified portfolio. Fixed income investments have historically provided ballast against stocks, which are more volatile. But investors are learning that prices for bonds can drop, especially in a rising interest rate environment.

Bond prices are best understood with a simple example. If you purchased a 10-year U.S. government bond that paid 1.6 percent a couple of years ago, it will be worth less now, when new bonds issued by Uncle Sam are paying almost 3 percent. Conversely, if you owned a bond that is paying 5 percent and your friend can purchase a new bond at just 3 percent, your bond is more valuable today than the prevailing bonds she can purchase. In other words, bond prices generally move in the opposite direction of prevailing rates, regardless of the bond type.

Here's where economics and the Federal Reserve come into the story. Inflation can hurt bonds, because the fixed stream of interest payments will be worth less over time due to rising prices. With inflation at four-decade highs, the value of your future bond payments is reduced, the Fed’s tightening campaign has added to the downward pressure on bond prices.

Make no mistake: the 2022 bond market drop has hurt. The Bloomberg Aggregate Bond Index tumbled 6.6 percent in the first quarter of the year, its worst three-month stretch since 1980. In general, riskier bonds (“high yield” or “junk”) and those with longer maturities fared worse, while higher quality and shorter-term bonds did better, but at the end of the quarter, no bond investor was pleased.

If you own an individual bond, the falling prices may be uncomfortable, but if you hold on until maturity, you will receive the face value of the bond. It’s tougher for those who have seen the prices of their bond mutual funds drop, with no relief in sight. Before you bail out of your bond positions and stash the proceeds in cash, stocks, or crypto, remember that even as bond prices drop, interest on the bonds within the mutual fund should continue to make interest payments. Then, as the bonds within the fund mature or are sold, they can be replaced with higher-yielding bonds, which could create more income for you in the future. Additionally, if you are reinvesting interest and dividends back into the fund, you may benefit from purchasing shares at lower prices.

And one more thought that might help prevent you from pushing the sell button on bonds: what seems like the worst asset class today can quickly turn into the hero of your portfolio when the economy and markets change, and they always do.