Last year was an extraordinary one for the bond market, and not in a good way.
The Bloomberg U.S. Aggregate Bond Index — a proxy for the broad U.S. bond market — posted a 13% loss in 2022, which, by itself, wouldn't be all that remarkable. But many investors hold bonds as a portfolio diversifier, an asset that's supposed to provide some ballast when stocks go down.
With the S&P 500 surrendering 18% last year, a major loss in the bond market was a rare and brutal shock to investors in mixed portfolios. It was the first time both indexes suffered double-digit losses in the same year since 1969.
So where does that leave bonds now? Potentially in a very attractive place. Many of the factors that hurt bonds in 2022 may work toward helping their performance in 2023, experts say. But that doesn't necessarily mean it's time to pile your portfolio into bonds.
"It's not a good time to say, 'There's a small opportunity in the bond market, so move,'" says Derek Pszenny, cofounder of Carolina Wealth Management. "It looks eerily like a market timing move."
Here's how the pros say to approach the 2023 bond market responsibly.
How interest rates affect bond returns
One key relationship explains why bonds did so badly in 2022: Bond prices and interest rates move in opposite directions.
"The Federal Reserve raised rates more than they have in 40 years. That caused massive losses inside of bonds," says Robert Gilliland, managing director at Concenture Wealth Management. "It's important to understand that bonds are generally secure, but not necessarily safe."
As a series of interest rate hikes eroded the value of bonds in 2022, it also did 2023 bond investors a couple of favors. For one, bonds are now offering more attractive interest payments to investors. At the beginning of 2022, a six-month Treasury bond paid an interest rate of 0.22%. The same bond today pays 4.76%.
What's more, the rapid series of increases last year may mean the Fed doesn't have much more hiking to do this year, especially if the economy begins to show signs of recession.
Long-term investors: Don't jump in without a plan
Even if bonds may seem attractive right now, that doesn't mean long-term investors should abandon an all-stock portfolio in favor of adding bonds, says Pszenny. While the bond market suffered in 2022, so did the tech stock-heavy Nasdaq 100, an index with greater potential for high long-term returns.
"You have to factor in the opportunity cost of leaving the equities market in favor of bonds," he says. "If you chase performance, you might end up shooting yourself in the foot."
In other words, if your original plans didn't include bonds, don't include them now. "Once you pick your asset allocation, unless something changes with your goals or time horizon, stick with your current allocation," Pszenny says.
If your plan already includes a bond allocation, consider moving to longer-dated bonds, Pszenny says. That's because bonds with longer maturities tend to be more sensitive to moves in interest rates. Should the Fed begin decreasing interest rates, long-term bonds will be the biggest beneficiaries, he says.
Short-term savers: Play it safe
Some of your investing goals may be coming up sooner than a long-term goal like retirement, such as hosting a wedding or buying a house. Depending on how far out your goal is, you may want to hold a mix of stocks, bonds and cash.
The sooner you'll need the money, the more cash you'll want. "If it's less than 24 months, you want virtually no risk," says Gilliland. "The reality is, you're getting 4% to 4.5% by being in short-term [certificates of deposit]."
In other words, now that interest rates are higher, you can earn a decent return by holding CDs and other cash-equivalent products that have virtually no risk of losing money, and that's important. Imagine going to put a down payment on your house only to find that the stash you had set aside has recently declined in value.
As you go further out, say between two and five years, consider adding bonds to your portfolio, sticking with short-term bonds with high credit ratings.
Higher rated bonds are less likely to default than issues with lower ratings. U.S. government bonds, for instance, carry the highest-possible AAA credit rating and have never defaulted.
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