Bonds have always been thought of as a vital part of any truly balanced investment portfolio. With stocks and bond often, but not always, being negatively correlated (prices move in opposite directions), bonds can help reduce the overall volatility of a portfolio. But 2022 changed much of what had been previously thought about bonds. When inflation began to skyrocket in early 2022, the Federal Reserve (Fed) took action to curb the path of inflation by rapidly raising interest rates beginning in March that year. By May, the Fed began raising interest rates at the clip of 0.75% (75 basis points) for four consecutive Fed meetings. This created the worst bond market performance in over a century, with the Bloomberg U.S. Aggregate Bond Index dropping more than 13% and long-term Treasury bonds sinking more than 29%.
This dramatically changed many investors’ view of the value of adding bonds to a portfolio when even the most conversative investors experienced losses that they never imagined could happen. The bond market remained negative through the end of October 2023 and achieved all the year’s gain in November and December.
Enter 2024 with investors anxiously awaiting the Fed to begin to cut interest rates that was thought to revive the sinking bond market. Most intermediate term bonds had near zero rate of return into the summer. Then it happened – at the Fed’s September meeting they voted to reduce interest rates by 0.50% (50 basis points). On the anticipation of the Fed taking this action, the bond market began to show signs of life.
One technique some investors employed to curb falling bond prices was to shorten the duration of the bonds they held. Duration is a measure of a bond’s sensitivity to changes in interest rates – short duration will be least affected by changing rates, long duration being the most affected. With shorter duration, bonds could better survive an environment of high inflation and high interest rates. Now that the Fed has begun cutting interest rates, many investors are rethinking the viability of investing in bonds once again.
When rates rose, duration was shortened. Now that the Fed has acted to cut rates, extending duration may make sense. Investors doing so are seeking to take advantage of the environment of softening inflation and interest rates which should positively impact the bond market.
Building the bond “sleeve” of a balanced investment portfolio, however, is more than just focusing on duration. What types of bonds to implement in a portfolio is also important. There are corporate, government, asset-backed bonds to name a few types available. Also, domestic vs. foreign bonds can play a vital role for overall bond diversification. Lastly, bond quality must be a consideration. In this uncertain environment, many investors focus on investment grade bonds, being AAA, AA, A and BBB rated. Lower quality bonds, often referred to as “junk bonds” may add additional diversification. Junk bonds tend to be more positively correlated to the stock market which can be beneficial when the stock market is rallying.
An investment professional can assist in developing a bond sleeve that works well with the stocks that are being held within an investor’s portfolio.