Bond Losses: When Pain Leads to Gain
Discrepancies - and hence opportunities - in securities originate most often when events move faster than quotations.
— Benjamin Graham
The recent losses for bond investors could mean additional future returns.
2022 was one of the worst years for bond returns. Conservative investors with portfolios which had larger bond allocations (to buffer volatility and for yield) would have suffered large paper losses as yields jumped up significantly — resulting in a collapse in bond prices — in the face of the fastest interest rate hiking cycle in history.
The diagram below shows the annual price return of the Global Aggregate Bond Index (hedged to SGD). 2022 was on track to be as bad or even worse than 1994 (a -12.5% loss) but instead, ended the year at -11.5%.
Buying at a Discount
When asset prices move significantly lower over a certain time period, it makes it cheaper to buy and also provides investors a great opportunity to achieve higher than average returns over the long term. For bonds in particular, investors have the chance to buy bonds at yield levels not seen since before the 2008 financial crisis. There is also an opportunity to generate some capital gains as many bonds are trading at levels below par.
Analysis by KKR below shows that the number of investment grade bonds trading at 80 or below (meaning a price loss of -20% or more) has reached levels even higher than the 2008 financial crisis. This is quite phenomenal - and unless you believe that another banking and housing collapse is upon us, then there is no reason why bonds should be priced in this manner for too long.
Fear & Concerns
However, many people could be hesitant to do so because of concerns about future increases in yields. Some may even be considering reducing their bond exposure after 2022’s negative returns for fixed income. After all, financial commentators and the news appear to suggest that the rate hiking cycle is not over yet.
Even if yields do keep rising, investors seeking higher expected returns would be better off maintaining the duration of their fixed income allocation - meaning that they shouldn’t reallocate or purposely seek out different types of bond investments just because of their prediction of where interest rates could go.
The example below shows what happens if you are suddenly hit with fixed income losses in your portfolio (this also assumes that you are holding a diversified and high quality portfolio). There are two investors who hold $100,000 worth of bonds.
The first investor (darker green) faces no change in interest rates and the bond yield stays at 1% throughout the holding period. There is no price change in his bond portfolio. He receives $1,000 a year and after ten years the value of the bond portfolio is around $110,000.
The second investor (light green) gets hit with a sudden spike in interest rates in the first investment year. Yields jump from 1% to 4% — similar to what we all experienced in 2022. The price of his bond portfolio dives to $86,000. However, because of the higher yield within his investments (now at 4%), his returns are higher over the longer term. His value overtakes the first investor after the fifth year. The value of the bond portfolio after ten years is around $130,000.
So there is no reason to fear higher interest rates. Investors and savers should rejoice that they are now being fairly compensated after suffering many years of near-zero yields. Financial research and data shows us that trying to reposition by holding onto cash, or shortening the duration, with the expectation of future yield increases is unlikely to help you achieve your long term goals.
A well-thought out and robust investment plan would have incorporated many possible bad scenarios and poor investment outcomes. Investors who maintain appropriate asset allocations, even after increases in bond yields, may have a more rewarding investment experience in the long run. If you have questions about how to create such an investment plan, come and speak with us.
