Why the Bond Market Looks Brighter Than It Did in 2022

Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton.

The bond market is jittery. A higher-for-longer environment for interest rates is persisting. A recent US government-bond selloff rippled across the world. None of this is making bond investors happy. But what if there’s some good news? Morningstar columnist Dan Lefkovitz believes there is. The Morningstar Indexes strategist joined Investing Insights to explain why it’s time to look to the positive.

Thanks for being here, Dan.

Dan Lefkovitz: Thanks so much for having me.

Bond Market in Q1 2025

Hampton: Well, let’s start with how the bond market is looking so far in Q1. We are going to timestamp this Feb. 20.

Lefkovitz: Things have sort of settled down in February, but we did have a bond market selloff in January. The start of the year, the yield on the 10-year Treasury was 4.5, and the first couple of weeks of the year, it got pushed to 4.8. So we saw the bond market, existing bonds lose their value. The Morningstar US Core Bond Index, which represents the investment-grade bond universe, Treasuries, corporates, agencies, declined about 1% just in a couple of weeks. Now, like I said, February, things have sort of moderated, and that yield on the 10-year Treasury is back down to 4.5. Our core bond index is now in positive territory for the year but only slightly.

Why Did the 10-Year US Treasury Yield Go Up After 2024 Interest-Rate Cuts

Hampton: The Federal Reserve cut interest rates three times in the final months of 2024, but the 10-year US Treasury yield went up instead of down. That probably surprised some folks.

Lefkovitz: Definitely.

Hampton: What’s going on?

Lefkovitz: Right. The assumption is the Fed’s cutting rates, you want to be in bonds, right? Bonds are going to appreciate in value if there are interest-rate cuts, and that did not happen. I wrote that bonds can’t catch a break because they’re losing money when the Fed is cutting rates, and they lost a lot of money when the Fed was raising rates a couple of years back in 2022. Some people called it the worst bond market ever because the Fed was jacking rates up so dramatically. And here we have interest-rate cuts, and yet our core bond index is in negative territory since September, which is when the Fed made the first of its cuts.

Now, I’d point to a few things to explain this. The election, of course, is a big factor, which we’ll talk about, inflation, and expectations that the Fed is not going to continue cutting rates but that rates are going to stay higher for longer.

Why Bond Investors Are Worried Following the US Presidential Election

Hampton: And let’s get into the election because market watchers are observing that the second Trump administration is having different effects on the stock and bond markets. Stocks are going up, bonds are falling. Why are bond investors worried?

Lefkovitz: Yeah, well, let’s start with the stock market. I mean, this performance divergence between stocks and bonds is really interesting, just the different ways they’ve interpreted the election results. But stock market has reacted to the Trump election in much the same way that it did in 2016 when Trump was first elected. Off to the races, big rally, expectations of turbocharged economic growth, tax cuts, deregulation, the unleashing of animal spirits, all of that. Protectionism, which would benefit domestically oriented businesses.

The bond market’s worried. The bond market is worried about the debt and deficits, tariffs, trade wars, tax cuts, all of this contributing to inflationary pressures. And as we saw recently, inflation is still coming in hot. It’s 3%. That’s down a lot from where it was. In mid-2022, it hit 9%. So 3% is not bad relative to 9, but the Fed’s target is 2, and we’re not getting there, and the bond market is worried.

What’s the Bright Side for Bonds?

Hampton: Got you. So you’ve written that there is actually a bright side for bonds. Let’s end the suspense. People are losing money in bonds, but why should they feel positive about it?

Lefkovitz: Yeah, well, OK, so first of all, they’re not losing that much money in bonds. Bonds are off. Our core bond index is in negative territory since September but only slightly. It’s not that dramatic. If you’ve got longer-dated bonds, you’ll have lost more money. But there’s an old adage that a bad year in the bond market is like a bad day in the stock market. So bonds are just a lot less volatile than the stocks. So it hasn’t been that much of a disaster.

The good news, as I see it, is that bonds and stocks have been moving in opposite directions. From a diversification perspective, that’s what we call negative correlation, and it means that assets, one asset is zigging while the other asset is zagging. And that’s what you want in your portfolio. You want assets that are going to respond to different stimuli and move in different directions.

And why it’s notable is that, in 2022, both stocks and bonds fell a lot, double-digit losses for both asset classes. I mentioned worst bond market ever. It was also a bear market for equities, and bonds did not provide any diversification benefit in 2022. And the big talk that year was the death of diversification and the end of the 60/40 portfolio--60/40 portfolio, that classic balanced mix between stocks and bonds. And here we have stocks and bonds zigging and zagging in different directions. So that’s a positive.

And I’ll note that, over last summer, early August, early September, we had selloffs in the equity market. The Bank of Japan raised interest rates. A few different things happened, and we saw selloffs in stocks. And during those selloffs in stocks, bonds appreciated in value. They acted like a safe haven. So we’re seeing more of the same, really, in recent months. Even though it’s been bad for bond investors, it hasn’t been dramatically bad. And yeah, I guess from a diversification perspective, I feel like it’s noteworthy.

The Importance of Portfolio Diversification

Hampton: And then the benefits of diversification has been tested handful of times since 2000. Why does Morningstar stress the importance of diversification?

Lefkovitz: So if you look at all the equity bear markets in this millennium, since 2000, we had the 2000 to 2002 bear market after the bursting of the internet bubble. And there was 9/11, and there was a recession in 2002. Stocks were down sharply. Morningstar US Core Bond Index was in positive territory in those years. Then we had 2008, the global financial crisis. The housing market collapsed. Huge equity market selloff, bonds were a safe haven. They diversified equity market losses that Core Bond Index positive. Early 2020, the pandemic panic, sharp selloff in the equity market and bonds appreciated. Bonds held their value and acted like a safe haven.

The correlations between these assets are always in flux. They’re always moving around. But we have seen that at times of stress for stocks, bonds have acted like that shock absorber for the portfolio. And that’s why 2022 was such a disappointment. And that’s why I’m noting that, in recent months, postelection or in the wake of these interest-rate cuts, we’ve had stocks and bonds moving in the same direction. And then in those equity market selloffs that we saw last summer, we’ve had bonds return to their role as portfolio ballast or shock absorber.

Morningstar’s 2025 Bond Outlook

Hampton: Got it. So what is Morningstar’s outlook for bonds for 2025? Where should investors look? Where should they not look?

Lefkovitz: Yeah, yeah, it’s interesting. So our colleagues on the investment management team at Morningstar, they actually saw that selloff that I talked about in January, the bond market selloff as an opportunity, as a great entry point for bonds. Lots of forecasters are actually expecting good things from bonds in the years to come. Now, if you look at the yield on our core bond index, it’s almost 5% now, which is great from an income perspective. It’s also great from a total return perspective because that yield is going to contribute to total returns going forward. And our colleague, Christine Benz, she compiles expert forecasts at the beginning of each year. The 2025 edition that she compiled, a lot of experts were actually expecting bonds to return more than US equities in the next 10 years. So I’m not sure. We might continue to see the upward pressure on the 10-year Treasury yield, which would be bad for bonds, but I think that bonds are more attractive now at this yield level than what we’ve seen for many, many years after the financial crisis. And that diversification benefit that bonds provide is really, I think, valuable.

Key Takeaways on Portfolio Diversification

Hampton: And we’ll put a link to Christine’s forecast article in the show notes, so be sure to check that. So we know that the bright side is that stocks and bonds are now negatively correlated, and that’s good for portfolio diversification. What other takeaway do you have for us?

Lefkovitz: One thing I’d say is that negative correlation could change, and in fact, we saw in 2022, stocks and bonds lose money together, so they’re not always going to be negatively correlated. Our colleague, Amy Arnott, here’s another one for the show notes, she did some great research on when stocks and bonds are positively correlated, and it often happens in inflationary environments when interest rates are getting jacked up. So that helps explain what we saw in 2022. Similar thing happened in inflationary episodes like in the 1970s.

So those two assets might not give you everything you need, especially in a really high inflationary environment. Maybe some real assets or natural resources, commodities--could provide some diversification benefit there. But I guess I’d say that, rules of thumb, like--OK, you want to be owning bonds in a falling interest-rate environment. OK, well, the Fed only controls the short-term interest rates. The longer-term interest rates are set by the market. So you got to be careful about that rule of thumb. And then stocks and bonds are always going to diversify each other--that’s not always the case either. So I would just be careful about rules of thumb. I like to say that we don’t have the immutable laws of physics in investing, right? It’s a little less predictable, the relationship between assets, than we often like to think.

Hampton: And that’s a good reminder. Another article for the show notes. Dan’s article, bonds might be losing money, but there’s a bright side. Dan, thank you for coming to the table. This has been a great conversation.

Lefkovitz: Thanks so much, Ivanna.

What’s New in the Markets?

Hampton: Here’s the markets in brief for the week ahead: Two big-box retailers are expected to update investors on how much shoppers are filling their carts. Target TGT is scheduled to report its fourth-quarter and full-year 2024 earnings on March 4. Costco COST is set to release its fiscal year Q2 2025 results on March 6. And just how resilient is the labor market? Market watchers are waiting for the answer from the Bureau of Labor Statistics. The February jobs report is due out on Friday, March 7.

• Target stock value TGT
• Costco stock value COST

Let’s shift to how owning too much company stock could expose your portfolio to significant risk. Restricted stock units, or RSUs, link your financial well-being to your company’s performance, and you’re already depending on them for your paycheck. If the company or sector took a hit, where would that leave you?

Morningstar researchers have investigated how to customize a stock portfolio to improve risk-adjusted returns. I spoke with Philip Straehl. He’s the chief investment officer for the Americas at Morningstar Wealth. It’s a part of registered investment advisor, Morningstar Investment Management.

Welcome to Investing Insights, Philip.

Phillip Staehl: Thanks for having me.

What Are Restricted Stock Units?

Hampton: Let’s start with a crash course on RSUs. What are they, and why do companies issue them to employees?

Staehl: RSUs are a form of stock-based compensation. So instead or in addition to getting a bonus or a salary, companies issue stock grants to employees as a way of incentivizing them. And the way they work, usually they have a four- to five-year vesting period. So over that time frame, you cannot trade them. And what we’ve seen is we’ve seen more and more companies using stock-based compensation or RSUs to incentivize employees. And so if we look at the data, that amount that companies spend on RSUs quadrupled over the past 10, 15 years. And so it’s been a pretty big increase.

And we also see not only growth companies or tech companies use them, we also see energy companies using them. And it’s also not just a phenomenon for executives anymore. We see more and more middle management people, and actually the majority of RSUs are issued to employees below the C-suite.

Risks Associated With RSUs

Hampton: Now folks listening or watching might be expecting RSUs or already have some sitting in their account. What are the risks associated with this type of compensation?

Staehl: A good way of thinking about it is to think about your personal balance sheet. And on the asset side of that balance sheet, you have stocks and bonds that might sit in your brokerage account in your 401(k). And if you have RSUs, you have another financial asset that sits on your asset balance sheet and you cannot trade that asset. And so we would encourage people to start thinking about the correlation of the RSUs, or the company stock, with the rest of your portfolio. So, for example, if you’re working for one of the big tech companies like Apple or Nvidia, you need to recognize that if you buy a large-cap US stock ETF, that you already have some of that exposure in your portfolio.

Examining RSU Risk Through Portfolio Personalization

Hampton: Good point. Now you and other Morningstar researchers have looked at these risks through the lens of portfolio personalization. What did you all find?

Staehl: We developed a framework to adjust an equity portfolio for these common risks. And so we looked at a few hundred companies, and we came up with a methodology to be able to tilt an equity portfolio away from the risks that you already have potentially in your RSUs. And what we found is that when we look at the total portfolio outcomes that we can deliver a similar or higher return, but we can significantly reduce downside risks because we’re not loading up on those same factors.

Understanding Concentration Risk’s Effect on Your Total Wealth

Hampton: Let’s talk about total wealth. I mean, it’s made up of financial assets like stocks and bonds, and there’s also human capital, or future earnings from your job. Can you give us an example or two when this pairing could create some concentration risk?

Staehl: Sure. So going back to the balance sheet that an investor has, we talked about financial assets thus far. But we also think that something called human capital, or the present value of people’s future earnings, should be included on the asset side of somebody’s balance sheet. And so you can think of somebody’s human capital as almost like a high-yield bond, like a risky bond. Think of your salary as a coupon you might be getting, and that coupon could be interrupted if you, let’s say, lose your job.

And so a recent example I’d like to give is looking at the banking crisis we’ve seen in the US a couple of years ago, and there’s one bank in particular, Silicon Valley Bank, that ended up being insolvent. If you think about an employee at Silicon Valley Bank, The Wall Street Journal reported that 18% of Silicon Valley Bank employees’ retirement accounts were invested in the company stock. And a lot of those employees also lost their job. So they effectively were faced with a double whammy. They lost the value of the stock, and they potentially lost their job, and the job is the human capital portion.

Another example is what happened during the pandemic to folks working in the leisure industry. So working for casinos, working for a cruise line, a lot of those companies had to lay off employees. And so if you think about the human capital of somebody working in an industry like that, that’s going to be correlated with financial assets as well. And so we would encourage folks to think about the correlation on the asset side of their balance sheet not only from a financial asset perspective but also in terms of the risks embedded in their human capital.

Do Separately Managed Accounts Offer Enough Personalization?

Hampton: Now, separately managed accounts offer common personalization options like excluding a sector. Do you think that’s enough in your opinion?

Staehl: We actually looked at that and compared it to kind of a more bespoke optimization. And what we found is that just taking the entire economic sector out--so let’s say if you’re working for a bank, take all of financial stocks out, or if you work for Apple or a technology company, taking the entire technology sector out. We found that that actually ends up not being a very well-diversified portfolio. And so we think you need to have a more nuanced approach rather than taking the entire sector out to be able to mitigate that risk.

How Should Investors Mitigate the Risk?

Hampton: So, if we’re going to do some nuance, how would an investor go about that?

Staehl: It’s a great question. In our paper, we use a risk model and we use an optimization framework, but we do think that an investor or an advisor can start thinking about those economic linkages. So if you’re working for a bank, perhaps take a look at the other banks you’re owning in your portfolio and start thinking about the wider industry or company risks that you already have associated with your company stock perhaps or with your human capital.

How Do Your Financial Goals Play Into Diversifying Your Concentrated Portfolio?

Hampton: What role would financial goals play in helping to diversify a concentrated portfolio?

Staehl: Great question. So what I like about this approach to personalization is that it ties into the broader financial perspective that somebody has. And so we think that building better-diversified portfolios and being cognizant of the risks that are already present on somebody’s asset side, if you will, that ultimately that will put somebody in a better position to achieve their financial goals. There’s other reasons to personalize. Some of these are more values-based, but our approach was more aligned with somebody’s financial objectives.

Do You Need a Financial Advisor to Diversify Your Portfolio?

Hampton: Is this something for a DIY investor, or should an investor say, “Hey, I need a financial advisor to help me with this.”

Staehl: I’d say it doesn’t hurt. It can be a little bit of both. I would say it’s helpful for people to, again, go back to understanding the risk they already have. And what we’re talking about here are nontradable assets. So company stock, they have a vesting period, you cannot trade them. Your human capital, you can also not trade that. And so we think it’s a good mindset for people to have and start thinking about those economic linkages we think is best practice.

Key Takeaways on RSUs and Portfolio Personalization

Hampton: What’s the key takeaway you want to leave us with? And it sounds like you were touching on it about the RSUs and portfolio personalization.

Staehl: Yes. I’d say that the key takeaway: Start thinking about your portfolio not just from the perspective of what you have in your brokerage account or your 401(k), open up the lens a little bit. Think about the nontradable wealth, and start applying the ideas behind diversification, the total wealth, not just the financial wealth that you have.

Hampton: Well, thank you for coming to the table and discussing how we can protect our total wealth.

Staehl: Thanks for having me.

Hampton: That wraps up this week’s episode. Thanks for watching and making this show part of your day. Subscribe to Morningstar’s YouTube channel to see new videos about investment ideas, market trends, and analyst insights. Thanks to Senior Video Producer Jake VanKersen, Associate Multimedia Editor Jessica Bebel, and Digital Communications Specialist Kumudini Devalla. I’m Ivanna Hampton, lead multimedia editor at Morningstar. Take care.

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