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Diversified Portfolios Still Need Bonds

January 26, 2023

2022 was a terrible year for bonds. Usually, if someone says they want to be “more conservative” a bond component is added or increased to a portfolio to reduce the risk inherent in stocks. Unfortunately, it didn’t work last year.

At different points during the year, bonds actually lost more than stocks. According to Edward McQuarrie, emeritus professor in the School of Business at Santa Clara University, performance “has never been worse than the last year.” McQuarrie further stated, “based on history, a year from now, I don’t think we’re likely to have had another year with losses like the last one.”

Investors are frequently told that bonds tend to be a ballast when stocks decline – often referred to as boring Steady Eddies. Until 2022. The disclaimer past performance is no guarantee of future returns was certainly true.

What happened? Inflation. The Fed raised interest rates seven times in 2022 to slow the economy and reduce inflation. This resulted in the drop of bond prices as interest rates rose. The current consensus is there is more to come but not at the levels seen in 2022 and potentially only the first half of 2023.

Regardless, on a long-term basis, bonds should still be part of a diversified portfolio. The silver lining is bonds and money market funds are paying interest – something that hasn’t happened for years.

Bond Basics

A bond is a loan. In exchange for receiving a loan, the lender expects interest payments and at the end of the term, a return of principal.

If you loaned the government $10,000 on January 1, 2022 for 10 years (equals a 10-year Treasury Note), the interest earned would have been, according to the Treasury Department – 1.51%.

If you were to loan the government $10,000 on December 29, 2022, the interest rate was 3.819%.

We’ve used the 10-year Treasury Note since it is considered risk-free because it is guaranteed by the U.S. Government.

Now, if you need to sell your Note, you aren’t going to find anyone willing to take it on if the interest paid is only 1.51% when a lender could go out and buy a new one paying 3.819%. Therefore, the $10,000 price must be reduced to become the equivalent of interest paid to the lender of 3.819%.

It is a mathematical calculation seen in the market every day.

Financial Connections continues to invest portfolios for the long-term that include bonds. Kathy Jones, chief fixed income strategist for Schwab Center for Financial Research stated, “Yields are already high enough that the outlook is quite good.”

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