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2022 has not been a great time for bonds. Year-to-date, the Bloomberg Global Aggregate Index and Bloomberg US Treasury Index returned -20% and -13%, respectively¹.  Meanwhile, risky asset classes also sold off significantly, which has led to many investors questioning the role of bonds as a diversifier to equities. 

While we acknowledge the frustration and the stress investors face in such a volatile market environment, it is important to avoid acting on impulse. Instead, investors should reflect on recent events to understand what has caused this massive drawdown in markets and then act accordingly by positioning their portfolios for the current economic backdrop. As always, it is important to take a long term view.

Reflect: understand what has happened so far

Bond markets were affected by a sharp and rapid increase in interest rates, triggered by increasingly hawkish developed market central banks, whose priority suddenly shifted to fight multi-decade high inflation levels.  

However, the extent to which bonds are impacted by an increase in interest rates depends on three main factors: 1) the magnitude of the increase, 2) the speed of the increase and 3) the starting level of yields. The slower the pace of rate hikes, the more income fixed income assets can accrue to offset the loss from rising rates. For example, during the 2015 to 2018 rate-hiking cycle, it took a year before the Fed undertook its second hike and a total of 36 months for rates to be hiked by 225 bps².

On the contrary, 2022 has been the perfect storm for fixed income markets where all the three factors mentioned above represented a headwind. To put it into perspective, since the beginning of the year, the yield on the US 

2-year Treasury – used as proxy for expected future Fed hikes – has increased 1) significantly (354bps), 2) rapidly (in only 9 months) and 3) from a very low starting yield (only 0.73%)³. As a result, fixed income assets were unable to accumulate sufficient income to help cushion the losses from rising rates. The combination of these three factors has been the main reason for the extreme market to market losses bonds have experienced so far this year.

Act: look forward and have a long term view 

While the Fed’s current hiking cycle remains uncertain, current bond prices already anticipate most of the increase. Looking at the Bloomberg Global Aggregate Index, the percentage of negative yielding assets has fallen from 16.5% at the end of 2021 to 7.8% at the end of September 2022⁴. At this point, the market has priced in a significant number of short-term rate increases in the coming months and longer dated US Treasury yields (e.g. 10-year) already reflect that. In fact, forward rates suggest relatively limited moves on longer dated yields in the next year, which should lessen the negative impact on bonds. 

Today’s starting yields also offer an attractive entry point for investors. Yields across fixed income sectors are sharply higher than their lows over the past few years. For example, high quality global investment grade corporate bonds currently offer a yield of 5.4%, which is higher than the 4.1% yield that was offered by global high yield corporate bonds during their recent lows in 2021⁵. At current yields, history suggests higher total returns over the next few years. This means that investors could benefit from holding bonds across fixed income asset classes, including high yield. This higher income can offer more of a cushion for total returns over time, even if price movements remain volatile. 

 

1. As at 30 September 2022. Source: Bloomberg 

2. Source: Bloomberg 

3. As at 30 September 2022. Source: Bloomberg 

4. As at September 2022. Source: Bloomberg 

5. Current yield as at 30 September 2022. Date of recent low is 6 July 2021. Source: Bloomberg