Did 2022 Prove That Bonds No Longer Diversify Stocks?
By Eli Breece ·
I keep seeing statements that ‘bonds no longer provide diversification relative to stocks’.
This is of course due to how historically bad bonds performed along with stocks in 2022 (classic recency bias).
However, this is the type of statement that leads me to believe many investors don’t know exactly what bonds were actually protecting investors from.
For many people, that experience called the entire purpose of bonds into question.
However, judging bonds solely by their performance in 2022 is a clear example of recency bias. It also reveals a misunderstanding of what bonds have historically protected investors against.
The chart below helps explain the distinction.
The horizontal axis shows annual stock returns, while the vertical axis shows annual bond returns. Each dot represents one year from 1926 through 2022.
The lower left quadrant represents years when stocks and bonds both lost money.
Despite covering nearly a century of market history, relatively few years appear in that quadrant. Most of the time, bonds generated positive returns during years when stocks declined (which is why bonds were historically considered a great diversifier).
But there is a reason in 2022 that stocks and bonds behaved in a correlated fashion as we will see in a moment.
Stocks and high quality bonds often respond differently to weakness in economic growth, which is ideal for diversification.
When economic growth slows, corporate revenue and earnings usually come under pressure. Investors may become less willing to pay high valuation multiples for those earnings, causing stock prices to fall.
That same slowdown can produce a very different result for bonds.
Weak economic conditions frequently reduce inflationary pressure and lead the Federal Reserve to cut interest rates.
So naturally, what happens?
Investors also tend to move toward safer assets when they become concerned about a recession or financial crisis.
Falling interest rates and greater demand for safety will push the prices of existing high quality bonds higher.
The Global Financial Crisis is probably one of clearest examples.
In 2008, U.S. stocks lost roughly 37%, while bonds gained nearly 20%, based on the asset classes represented in the chart. The economy was contracting, corporate earnings were collapsing, and the financial system was under enormous pressure. The Federal Reserve responded by cutting interest rates aggressively.
Bonds performed exactly as investors would have hoped.
Their gains helped offset some of the losses from stocks and provided investors with a more stable source of capital that could be used to fund expenses or rebalance into equities at depressed prices.
This is a good example of diversification.
The experience in 2022 was fundamentally different because the primary threat was inflation rather than collapsing economic growth.
Inflation surged to its highest level in decades, forcing the Federal Reserve to raise interest rates at one of the fastest paces in modern history. Higher interest rates pressured stock valuations, particularly among expensive growth companies whose valuations depended heavily on profits expected far into the future.
But those same rate increases also hurt bonds.
When newly issued bonds begin offering higher yields, older bonds with lower fixed coupons become less attractive. Their prices must fall to offer buyers a competitive return.
The longer the bond’s duration, the more sensitive its price generally is to changes in interest rates.
As a result, stocks and bonds were reacting to the same economic problem.
Rising inflation pushed interest rates higher, reducing both stock valuations and bond prices.
This is the key distinction investors need to understand:
- A growth shock can hurt stocks while helping high-quality bonds.
- An inflation shock can hurt stocks and bonds simultaneously.
The rarity of the lower left quadrant in the chart does not mean that stocks and bonds can never decline together.
But with that being said... It does show that such an outcome has historically required a particular set of economic conditions.
Think about what was actually happening during the year in that lower left quadrant.
In 1931, the United States was dealing with banking failures and severe deflation during the Great Depression. In 1969, inflation and tighter monetary policy created pressure across financial markets. In 2022, inflation again forced the Federal Reserve to raise rates aggressively.
Different periods produced different economic challenges, but 2022 stands out because the speed and scale of the increase in interest rates created one of the worst environments possible for a portfolio of both stocks and longer-duration bonds.
There is also an important distinction between different types of bonds that we must take into consideration.
Long-term Treasury bonds are highly sensitive to changes in interest rates but may provide substantial protection during a deflationary recession. Short-term Treasury bills carry much less interest-rate risk and may hold up better when rates are rising. Corporate bonds are exposed to both interest-rate risk and credit risk, while high-yield bonds can behave more like stocks during recessions because investors become concerned about defaults.
Simply saying “bonds” overlooks these meaningful differences.
An investor who wants protection against a recession may prefer high-quality Treasuries. An investor who is concerned about rising inflation may hold shorter-duration bonds, Treasury inflation-protected securities, or other assets that are less sensitive to rising rates. No single asset can protect a portfolio from every possible economic shock.
The investor’s time horizon matters as well.
A decline in bond prices is painful in the short term, but higher interest rates allow the portfolio to reinvest its income at better yields. For long-term investors, that can improve expected returns after the initial loss. The sharp bond selloff of 2022 therefore created a much stronger starting point for future bond returns than investors had when yields were near historic lows.
This does not erase the losses from 2022, but it does demonstrate why one unusually bad year should not be used to declare that the historical relationship between stocks and bonds is permanently broken.
The lesson from 2022 is more detailed and nuanced.
Bonds absolutely remain useful portfolio diversifiers, particularly during recessions, financial crises, and other shocks that weaken economic growth and cause interest rates to fall.
However, they are considerably less effective when the main threat is unexpectedly high inflation combined with rapidly rising interest rates.
Investors (and even financial professionals) continue to make the mistake that bonds are automatically diversifiers, but that is simply not the case.
Bonds diversify a portfolio against specific economic conditions, particularly recessions and growth shocks that cause earnings, inflation, and interest rates to fall.
BUT-
They offer far less protection during an inflation shock, when rising interest rates can pressure stocks and bonds at the same time.
This is why investors need to understand the economic risks each asset is designed to address. No asset will protect a portfolio from every possible scenario.
The lesson from 2022 is that diversification requires more than combining stocks and bonds. It requires understanding what you own, why you own it, and which risks it is actually capable of protecting you against.