Don't bail on bonds markets just yet

What happens when the so-called “safe” part of your portfolio loses value? That's the conundrum that diversified investors are facing, as they confront this year's drop in bond prices. While most are used to absorbing the swings in riskier assets, the 2022 bond market rout is unrecognizable to many.

Before you bail on your bonds, let's talk about how to think about the current situation.

First, an overview.

A bond purchase is essentially a loan to an entity, which can be a government, a state, a municipality, or a company. The loan is established for a predetermined period (30 days to 30 years), at a fixed rate of interest (hence the asset class's official name, “fixed income.”) Borrowers are on the hook for interest payments, either at periodic intervals (usually every six months), or at the end of the agreement, when they repay the obligation in full.

Because bonds deliver a consistent stream of income, investors have seen them as an integral part of diversified portfolio. Fixed income investments have historically provided ballast against stocks, which are more volatile. But investors are learning that prices for bonds can drop, especially in a rising interest rate environment.

Bond prices are best understood with a simple example. If you purchased a 10-year U.S. government bond that paid 1.6% a couple of years ago, it will be worth less now, when new bonds issued by Uncle Sam are paying almost 3%. Conversely, if you owned a bond that is paying 5% and your friend can purchase a new bond at just 3%, your bond is more valuable today than the prevailing bonds she can purchase. In other words, bond prices generally move in the opposite direction of prevailing rates, regardless of the bond type.

Here's where economics and the Federal Reserve come into the story. Inflation can hurt bonds, because the fixed stream of interest payments will be worth less over time due to rising prices. With inflation at four-decade highs, the value of your future bond payments is reduced. Concurrently, to combat high inflation, the Fed has started a campaign to raise short-term interest rates, adding to the downward pressure on bond prices.

Make no mistake: the 2022 bond market drop has hurt. The Bloomberg Aggregate Bond Index tumbled 6.6% in the first quarter of the year, its worst threemonth stretch since 1980. In general, riskier bonds (“high yield” or “junk”) and those with longer maturities fared worse, while higher quality and shorter-term bonds did better, but at the end of the quarter, no bond investor was pleased.

If you own an individual bond, the falling prices may be uncomfortable, but if you hold on until maturity, you will receive the face value of the bond. It's tougher for those who have seen the prices of their bond mutual funds drop, with no relief in sight.

Before you bail out of your bond positions and stash the proceeds in cash, stocks, or crypto, remember that even as bond prices drop, interest