Bond Investors, Don't Fret
Key Takeaways
2022 was one of the worst years for bonds in over 40 years.
Rate hikes (that began in March 2022) are a large reason why bond prices have dropped, but they’ve also improved the outlook for returns.
If you’re holding a good quality and diversified bond investment, the recent volatility means little in the long-run, it could even lead to net positive gains.
History provides a crucial insight regarding market crises:
they are inevitable, painful and ultimately surmountable.
The rise in rates in 2022 and this year has resulted in a difficult time for bond investors. Exceptionally high inflation coming from a post-COVID world has created a nearly coordinated policy response from central banks around the world. This has resulted in a series of exceptionally quick rate hikes, which has pushed down bond returns across all major fixed income markets. This made 2022 one of the worst years for bonds in a very long time.
The chart above shows just how bad the 2022 bond sell-off was. If you held a diversified portfolio of investment grade global bonds, you would be sitting on more than a -10% capital loss. If you held single company bonds or long duration government bonds, you may be facing even larger capital losses (E.g. Riskiest bonds for some Asian banks fall by record on Credit Suisse rescue deal, 2022 was the worst-ever year for U.S. bonds).
After the financial crisis of 2008, central banks around the world flooded the financial system with money, driving interest rates down, in an attempt to stimulate growth and provide a sort of jumpstart for the economy. As such, savers and bond investors have been plagued by extremely low rates for over a decade. This has forced many to reach for yields in higher risk instruments.
Now, in addition to this backdrop, add in the recent bond sell-off, which has hit more conservative investors and or those nearing retirement (already in the de-cumulation phase) the hardest. But there is a silver lining. Given the rise in interest rates, investors can now reinvest cash flows in bonds with higher coupons. Let’s break it down:
The diagram above shows a $100 investment in U.S. bonds made on 31 December 2021, which had a median projected value of $122 in 10 years’ time. The interest rate hikes (that began in March 2022) have dragged down bond prices, but they’ve also improved the outlook for returns. The same aforementioned bond investment now has a median projected value of $133, about 9% higher in ten years' time because of higher yields.
Would forecasting where rates may go help? Some financial strategists say bonds are looking attractive now because the Fed is nearing the end of its hiking cycle (e.g. End of cycle looks in sight for the ECB and the Fed, Fed closing in on end of rate hiking cycle). Let’s explore what that means for investors.
When looking at market prices of Fed funds futures, it appears that expectations are for one or perhaps two more hikes before the end of the year — before interest rates gradually get reduced.
Source: Bloomberg
There is no need to guess or forecast as these prices adjust to whatever is happening in the world every single day. However, given that yields on short duration bills and government bonds are much higher than longer maturity ones, it may seem logical that an investor would want to seek a higher exposure in this area.
So why not take a tactical approach and shift your fixed income exposure to short-term securities as long as rates are high at the moment? It’s actually not that simple — to do that successfully, you would need to get a lot right.
First, you would need to enter the trade sufficiently early so as to get an attractive price, but at the same time, not so early as to experience “negative carry” — where the capital loss on the bonds outweigh their yields.
Next, you would need to know when to exit just as yields are declining and bottoming out.
And finally, you would also need to check whether all these movements lead to excessive turnover in your investment portfolio, resulting in higher costs or possible taxes.
The chart above shows the relationship between the starting yield and the future 10-year annualised returns — On the left, for 3-month Treasury bills and on the right, 10-year Treasury notes.
For short-term bonds or bills, the fact that they mature so quickly and need to be reinvested into something else means that there is almost no relationship to what their yield is now and your longer term expected return.
However if you are holding a more “traditional” type of bond investment or fund with a longer maturity, the starting yield has a closer correlation to your long term returns. At the moment, for some of the core bond funds we utilise, the yield to maturity ranges from 4 to over 6%. This is a good yield — coming from something that you can sit on for quite a number of years to come.
So it is likely not worth it to keep switching between your fixed income investments just because of how interest rates moved or where you expect it to be.
For disciplined investors who have a well constructed investment plan, the best option now is to sit through the current turmoil in bond markets. Both your stock and bond allocations will be well-positioned to benefit from a return to more normal interest rates and equity valuations. So like the quote at the beginning of the article, market crises (in this case; bond crisis) are painful but over the long-term you will see the recovery to even higher levels.
To find out more about how portfolio construction can benefit you over the long term or how the construction can ride through different market cycles, come and have a chat with us.
