WHAT ACTIONS SHOULD I TAKE?
The Bloomberg U.S. Aggregate Bond Index experienced its worst-performing quarter in over 40 years, losing 5.93% from January to March. Many investors are frustrated that the index is down more than 10% (as of late April) from its high watermark. Bonds have traditionally been viewed as a low-risk vehicle for investing, providing reliable income and preservation of principal.
Stocks and bonds have traditionally demonstrated an inverse relationship. Generally, when stocks decline, bonds increase in value due to an increased demand for defensive assets. The first quarter of 2022 delivered negative returns across all major stock indices, and bonds failed to provide downside protection.
What Factors Impact Bond Pricing?
Pricing of the bond market can be confusing to the most experienced investors.
- Bonds prices and interest rates have an inverse relationship. If interest rates increase, previously issued bonds lose value because an investor can buy new bonds with the same maturity date and receive a higher yield (and income stream).
- Long-term bonds will experience greater losses compared to short-term bonds when interest rates increase. An investor’s primary source of return from investing in bonds is the recurring cash flow. Receiving an interest payment below market rates for eight years is less desirable than accepting a discounted rate for two years. Think of a bond as a contract like that of a physician or professional athlete. If you are an employee with a below-market deal, you would prefer a short-term contract over an eight-year agreement. The comparison holds true in the opposite scenario. When bond yields decline, the bonds you purchased a year ago are suddenly more valuable. An investor would prefer owning a long-term bond in a falling rate environment. The same can be said if physician compensation were falling. You would prefer to be locked into a multi-year contract rather than a 1-year deal expiring at an inopportune time.
- Credit quality can also impact bond prices. If the financial health of the company or municipality issuing the bond is in question, the price of the investment can fall. Credit qualify was not a factor in declining bond prices in the most recent quarter.
Why Did Bond Prices Decline?
The simple answer is rising interest rates. Inflation is running at a rate of 8.5% for the 12 months ended March of 2022[i]. One of the tactics used to control inflation, is to raise interest rates. The FOMC directly sets short-term interest rate policy through the Federal Funds Rate. Bond markets anticipate the Fed will increase short-term rates by 0.50% in May, and the same futures markets are predicting short-term rates will reach 3% next year. The Fed has been very transparent about its desire to raise rates, and the latest inflation reports have suggested the FOMC will act sooner than what the market anticipated three months ago.
Intermediate and longer-term rates are not directly controlled by the Fed, however, the FOMC does have the ability to influence these rates. The Fed owns an enormous portfolio of Treasury bonds and mortgage-backed securities. Notes from the last Fed meeting indicate the FOMC intends to sell $95 billion of bonds per month, which will increase supply and potentially result in higher yields. Markets are forward-looking; therefore, rates have moved higher in anticipation of the Fed’s actions.
In summary, the combination of Fed policy and inflation exceeding consensus expectations created a devastating combination for the bond market.
What Action Should you be Taking?
The question we are regularly asked: Should I sell all my bonds?
Before answering this question, it is important to remember markets are forward-looking. The bond markets are attempting to predict the next 12 months. If your investment decisions are based on today’s news, you are acting on information that is already priced into the markets. Predicting bond prices is nearly as difficult as predicting the direction of stocks. Experts had been calling for rising rates since the financial crisis of 2008, suggesting unprecedented stimulus programs would force yields to skyrocket. Bond yields proceeded to spend the next 12 years declining, which means existing bonds increased in value.
A case can be made intermediate bond yields have peaked. If stocks continue their downward trend and the economy enters a recession, the Fed would almost certainly be forced to alter its current intentions. In a scenario where consumers modify spending habits or supply chain disruptions are eased, inflation would quickly be stopped in its tracks. A call for higher rates is effectively a prediction that the economy will remain strong over the next 12-24 months. In this scenario, a balanced portfolio with a combination of stocks and bonds would be optimal.
All-in or all-out strategies are rarely successful and require perfect timing on both sides of your trade (when to get out and when to get back in). Investors should understand alternatives. Stocks, commodities, cryptocurrency, real estate, and private investments all result in a drastically higher degree of risk.
What about a move to cash equivalents? Bond yields continue to exceed cash yields, and as rates have increased the spread between the two has widened. Inflation negatively impacts purchasing power and cash is not risk-free in such an environment. Maintaining a cash position yielding 0.5%, while inflation is at 5%, results in a negative real return of 4.5%. Bonds offer a superior income stream to cash equivalents, and now have a higher likelihood of outperforming given yields are 2.0-2.5% higher than cash alternatives.
If an investor is convinced rates are likely to continue to climb, a recommended strategy is to shorten the duration of their bond portfolio (the average maturity of the bonds). A diversified short-term bond portfolio will regularly have bonds maturing (returning your initial investment). The injection of cash from the maturing bonds can be used to purchase new bonds at higher rates.
Another potential solution for qualified investors is to purchase individual bonds in addition to owning more diversified ETFs and bond funds. An individual bond will return full principal upon maturity, therefore interest rate changes occurring between the purchase and maturity date of the bond do not impact receipt of the original investment. The purchase of individual bonds rather than bond ETFs or bond funds can add concentration risk, credit risk, and liquidity risk and should be discussed with a professional prior to trading.
We recommend discussing the strategies referenced in this article with a trusted advisor, to ensure they are appropriate for your unique circumstances.