Bonds Are in a Bear Market. How to Play What Happens Next.

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Red-hot inflation and rising interest rates have hammered the global bond market. From Treasuries to junk bonds, debt investing is down in the dumps—but what happens next in terms of rates and the economy won’t treat all bond funds the same.

Friday ushered in a landmark moment in this monthslong rout, with the Bloomberg Global-Aggregate Total Return Index now more than 20% below its early 2021 peak. The decline marks the start of a bond bear market—the first in a generation.

A look at bond exchange-traded funds highlights the carnage. Investors who are long U.S. Treasuries with the

iShares 20+ Year Treasury Bond ETF
(ticker: TLT) are down more than 24% so far this year, or 26% over the past 12 months, on a price basis. The

iShares iBoxx $ Investment Grade Corporate Bond ETF
(LQD) is in similar shape, down more than 20% this year on a price basis. On a total return basis, TLT has lost 25% in 2022 and LQD has slid 17%.

Total returns have been abysmal across the bond landscape. The

iShares Core U.S. Aggregate Bond ETF
(AGG),

SPDR Bloomberg High Yield Bond ETF
(JNK), and

Vanguard Total World Bond ETF
(BNDW) each have lost investors between 11% and 13%.

The

Dow Jones Industrial Average
was down about 13% so far this year late on Friday afternoon, and the

S&P 500
was off about 17%. Holding bonds hasn’t helped investors pick up the pieces.

“2022 has been one of the worst years for a traditional 60/40 portfolio, primarily because bonds have not played their part as portfolio diversifiers,” strategists at PGM Global wrote in a note Friday, referring to a classic portfolio of 60% stocks and 40% bonds.

What comes next likely will depend on whether interest rates continue to rise, and on whether the U.S. slips into a recession. Different kinds of debt will perform differently in those scenarios.

Rate risk hits government debt particularly hard, while credit risk is felt more in high-yielding debt or “junk” bonds. If rates continue to push higher but the U.S. avoids a recession, junk bonds like those in the JNK ETF would likely outperform—dodging the worst of the impact from elevated rates while skirting the credit losses that could be expected in a recession.

But if there is a recession, and the Federal Reserve moves to eventually cut rates and ease off its fight against inflation, ETFs like TLT would outperform. These bonds are exposed to rate risk, but not the credit risk that comes with junk bonds, since their issuer is the U.S. government. Junk bonds would likely be beaten down in a recession as borrowers come under pressure.

The PGM Global team believes high-yield debt is somewhat at risk. Fed Chairman Jerome Powell made clear in last week’s speech at the Jackson Hole economic conference that the central bank is committed to fighting inflation with higher interest rates, and acknowledged the risk of a slowdown, the team said in a research note.

“The Fed’s ultra-hawkish rhetoric at Jackson Hole should start re-pricing credit risk in pockets of the high-yield space,” they wrote. “As growth wanes and tighter monetary policy bites, we expect to see worse performance in high-yield. This is particularly true if energy prices continue to weaken, given the support high-yield Energy has provided to the overall high-yield complex.”

If there is a recession but inflation persists, forcing the Fed to keep turning the screws on financial conditions, the bond bear market might only get hairier. Investors would likely want to move into cash.

It may be tough to remain optimistic. In a note Thursday, analysts led by Michael Hartnett at

Bank of America Securities

outlined what they see as a coming “fast inflation shock, slow recession shock,” which is likely to see yields push even higher.

“Nominal growth continues to be boosted by inflation, fiscal stimulus, past era of wealth accumulation, new era of ‘economic cancel culture’ (economic pain elicits immediate public sector bailout); and war always inflationary; housing only sector showing sinister trends right now,” Hartnett’s team wrote. They see inflation likely to fall below 4% by 2024, with 10-year yields likely to exceed 4% by that year, arguing that the U.S. is likely to tip from inflation to recession.

But optimism may be called for. Bond investors now have history on their side, according to Mark Haefele, the chief investment officer at UBS Global Wealth Management.

For one, bond yields are at their highest level since the 2008-2009 global financial crisis, Haefele said in a note Friday. The starting level of yields tends to provide a good guide for future returns, which suggests that the outlook is now much stronger than it has been for most of the period since the crisis, he added.

In addition, “periods when 12-month rolling total returns simultaneously fall for both stocks and bonds are rare, but the subsequent performance has been good,” Haefele said. “Since 1930, the 12-month bond performance following such periods has been positive 100% of the time, with an average return of 11%.”

Write to Jack Denton at jack.denton@dowjones.com