Khan Capital | October 2022
Key Takeaways
- The Bloomberg Global Aggregate Bond Index has fallen approximately 20%, erasing $10 trillion in value in what Deutsche Bank and Bank of America estimate is the worst year for government bonds in at least 250 years.
- The severity reflects unique starting conditions: historically low yields (maximising duration sensitivity) combined with historically fast rate increases from synchronised global central bank tightening.
- The 60/40 portfolio has suffered its worst year since 2008 as the stock-bond correlation turned positive, a structural feature of inflationary regimes that challenges the foundational assumption of modern portfolio construction.
- The universe of negative-yielding debt has collapsed from $18 trillion to below $1 trillion, marking the end of an era in which investors paid governments for the privilege of lending them money.
- Current yield levels (10-year Treasury at 4%+, investment-grade at 5.5%+, high-yield at 9%+) represent the most attractive entry point for income investors in over a decade, even as the secular bond bull market that defined the previous four decades has ended.
The global bond market is experiencing its worst year in centuries. That is not hyperbole. The Bloomberg Global Aggregate Bond Index has fallen approximately 20% year-to-date, a decline unprecedented in the index’s history and, according to estimates from Deutsche Bank and Bank of America, the worst calendar-year performance for government bonds dating back to the 18th century. The US 10-year Treasury yield has surged from 1.5% at the start of the year to above 4.2%. German 10-year Bund yields have swung from negative 0.18% to above 2.3%. UK gilts suffered a near-systemic meltdown during the mini-budget crisis of September. The 40-year bull market in bonds, which began with Paul Volcker’s inflation-fighting campaign in the early 1980s and produced decades of falling yields and rising prices, is over.
The Scale of the Repricing
The numbers are staggering by any historical standard. The total market value of the Bloomberg Global Aggregate, which tracks investment-grade government and corporate bonds worldwide, has declined by approximately $10 trillion in 2022. The 30-year US Treasury bond has lost over 35% of its value, a decline that exceeds many equity bear markets. Austrian 100-year bonds, issued at near-zero yields in 2020, have lost approximately 60% of their value. The universe of negative-yielding debt, which peaked at approximately $18 trillion in late 2020, has effectively been eliminated, falling below $1 trillion.
The repricing has been driven by a single force: the coordinated global tightening cycle that has seen virtually every major central bank raise interest rates simultaneously. The Federal Reserve has hiked 375 basis points. The European Central Bank has raised by 200 basis points, its fastest tightening ever. The Bank of England has hiked 290 basis points. The Bank of Canada, Reserve Bank of Australia, Riksbank, and Swiss National Bank have all tightened aggressively. The only major holdout is the Bank of Japan, which has maintained its yield curve control policy, a stance that has placed it in increasingly stark contrast with its peers and contributed to the yen’s collapse to 30-year lows.
Why Bonds Have Never Fallen This Much
The severity of the 2022 bond bear market reflects the unique starting conditions from which the repricing began. Yields entered the year at or near the lowest levels in recorded financial history, which meant that the mathematical sensitivity of bond prices to yield changes (duration) was at its maximum. A 200-basis-point rise in yields produces a far larger percentage price decline when starting from 1% than when starting from 5%, because the duration of a bond increases as its yield falls. The combination of historically low starting yields and historically fast rate increases produced a price decline that has no precedent in modern financial history.
The previous secular bond bear market (1946-1981, when yields rose from approximately 2% to 15%) played out over 35 years, giving investors decades to adjust. The 2022 repricing has compressed a significant portion of that adjustment into a single calendar year, driven by the speed and magnitude of the central bank response to inflation that proved far more persistent and broad-based than the “transitory” consensus of 2021 had assumed.
The Casualty List: What the Bond Bear Has Broken
The 60/40 portfolio. The assumption that bonds provide a positive return cushion when equities decline has been the cornerstone of portfolio construction for four decades. In 2022, the stock-bond correlation has turned sharply positive: both asset classes are falling simultaneously as rising rates compress equity valuations and erode bond prices. The 60/40 portfolio is on track for its worst year since 2008, and the structural lesson, that positive stock-bond correlation is a feature of inflationary regimes, will reshape institutional asset allocation for years.
Pension funds and insurance companies. The UK mini-budget crisis of September exposed the vulnerability of pension funds that had used leveraged LDI strategies to match their long-dated liabilities. The gilt market sell-off triggered margin calls that produced a doom loop of forced selling, requiring Bank of England emergency intervention. While the UK crisis was the most acute, the underlying vulnerability (leveraged positions in sovereign bonds that assumed yield stability) exists in pension systems globally.
Emerging markets. Rising US yields and a surging dollar have tightened financial conditions for emerging market borrowers, many of whom have significant dollar-denominated debt. The combination of higher borrowing costs, capital outflows, and depreciating currencies has pushed several frontier economies toward debt distress, with Sri Lanka, Ghana, and Pakistan among the casualties.
Real estate. Mortgage rates in the US have doubled from approximately 3% to over 7%, the fastest increase in decades. Housing affordability has collapsed, and transaction volumes have plunged. Commercial real estate, particularly office properties facing the structural challenge of remote work, faces a repricing that is still in its early stages as higher cap rates reduce property valuations.
What the Market Is Misunderstanding
The secular bond bull market is over, but that does not mean bonds are uninvestable. The 40-year regime of falling yields (and therefore rising bond prices) has ended. But bonds at current yield levels are more attractive than they have been in over a decade. A 10-year Treasury at 4%+ offers a real yield (after expected inflation) of approximately 1.5-2%, the highest since the pre-financial-crisis era. For income-oriented investors with long holding periods, the entry point is compelling even if the direction of yields remains uncertain.
Duration management is now the critical fixed income skill. In a falling-yield environment, duration was a source of return (longer-duration bonds appreciated more as yields fell). In a rising-yield environment, duration is a source of risk. The ability to actively manage portfolio duration, shortening it when yields are rising and extending it when yields peak, has replaced passive buy-and-hold as the essential fixed income strategy.
The bond market is signalling recession risk. The yield curve has inverted deeply (2-year yields exceeding 10-year yields by over 50 basis points), the most reliable recession indicator in the fixed income market. While inversion does not predict the timing of recession with precision, every US recession since the 1960s has been preceded by yield curve inversion. The bond market is telling a different story from the equity market, and historically, the bond market has been right.
Implications for Investors
Yields at current levels represent a generational entry point for income investors. A 10-year Treasury at 4%+, investment-grade corporate bonds at 5.5%+, and high-yield credit at 9%+ offer the most attractive starting yields in over a decade. For investors with time horizons that match the duration of their holdings, the income component of fixed income returns is finally meaningful again.
Short duration remains the risk-managed approach. Until there is clear evidence that the rate-hiking cycle has peaked and inflation is sustainably declining, the risk of further yield increases argues for keeping duration shorter than benchmark. The front end of the curve (2-year Treasuries, floating-rate instruments, money market funds) offers attractive yields with minimal rate sensitivity.
TIPS offer value at current real yield levels. With real yields on 10-year TIPS approaching 2%, these instruments provide explicit inflation protection at a price that has not been available in over a decade. If inflation remains above 2%, TIPS holders are protected; if inflation falls and the Fed cuts rates, TIPS prices appreciate.
Alternatives to traditional bonds deserve increased allocation. Commodities, infrastructure, floating-rate loans, and short-duration credit provide income and diversification without the duration risk that has made traditional bonds so destructive in 2022.
Conclusion
The worst bond bear market in centuries has destroyed $10 trillion in value, broken the 60/40 portfolio, exposed leverage in pension systems, and ended the assumption that government bonds are “safe” assets in any environment. But destruction creates opportunity: yields are now at their most attractive levels in over a decade, the income component of bond returns is meaningful again, and the very repricing that has caused so much pain has created a foundation for more sustainable returns in the years ahead. The bond market’s 40-year bull run is over. What replaces it, a range-bound market, a new secular bear, or something in between, will depend on the trajectory of inflation, the endpoint of the tightening cycle, and the fiscal policies of governments that have grown accustomed to borrowing at historically low rates.
Related Reading
The bond bear market was driven by the hiking cycle covered in The Fed’s Most Aggressive Hiking Cycle. For the UK’s fiscal policy crisis within this bond market, see UK Mini-Budget Crisis. For how yields later spiked to 5%, see 10-Year Treasury Hits 5%.
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