The year 2022 will go down in my book as the worst year in history for the U.S. investment markets. Why do I assert that so strongly? It’s because of what happened to bonds.

The S&P 500 lost -18.1%, making 2022 merely the seventh worst year since 1926. But that wasn’t the main story. The Bloomberg Barclay’s Aggregate Bond Index – which had never fallen by more than -2.9% since its inception in 1973 – declined by a whopping -13%. Ten-year U.S. treasury bonds suffered a 16% loss, their worst return in nearly a century. The bond portion of a portfolio is supposed to act as a stabilizer against the volatility contributed by riskier assets such as stocks and real estate. And the safest bonds such as U.S. treasuries typically shine during years with economic turmoil. Not this time.

Anyone investing in the capital markets over the last twenty years should be familiar with the volatility equities undergo. Stocks had great returns over the last decade but crashed in 2008 as well as during 2000-2002. That’s the reason conservative investors maintain large portions of their portfolios in bonds or bond mutual funds. They never expected to have double-digit losses in 2022. That’s what made last year so devastating.

A number of people have asked me if diversification still works. Yes, it worked even during 2022. A 60% stock/40% bond portfolio would have lost less (-15%) that a total S&P 500-based equity portfolio (-18%). But that’s not much consolation to investors who expected better downside protection.

What caused all this fixed income carnage? A major factor was the most aggressive reaction ever taken by the Federal Reserve (Fed) to a spike in inflation. The frequency and amounts by which they raised short-term interest rates throughout the year caused bond prices to plummet.

In defense of the Fed, they will almost always find themselves behind the curve when it comes to fighting inflation since it’s so difficult to predict the scope of near-term economic shifts. And the post-Covid environment, with its supply-chain disruptions and government-stimulated explosion in consumer demand, was practically unprecedented. Having said that, many economists view the Fed as overreacting right now when by many measures inflation has been waning. And there’s also nothing sacrosanct about the Fed’s announced target of a 2% inflation rate. 

It’s important to note that there are many different types of bonds with diverse characteristics. Some multi-sector bond funds lost less than -8% last year. Which indicates that diversifying the fixed-income portion of your portfolio is just as important as diversifying the overall portfolio.

So congratulations on having made it through 2022! While the 2023 outlook for stocks remains murky, the outlook for bonds is much brighter. Once the Fed stops raising interest rates (which will hopefully happen soon), bonds will start to yield returns not seen for decades. And if the economy should enter a recession, the Fed might even reverse course and start reducing rates. That would provide an even bigger boost to bonds.