10.31.22
For Bond Investors, Is It The Worst of Times — Or The Best?
by: Rich Blake
So much for bonds being boring. But while steep rate increases have wrecked portfolios, “fixed-income math” is back at the fore of advisor-client conversations.
To quickly recap, the pandemic hit, stimulus rained down, supply chains bottlenecked, Russia invaded Ukraine and consumer prices skyrocketed, throwing theglobal economy off its moorings.Then, central banks reached for the singular policy lever at their disposal —control over interest rates —which shot dramatically higher in 2022.
Bond markets shifted dramatically as well. Prices and interest rates (yields) move in opposite directions. That steep rise in rates caused bond prices to plunge.
Silver Linings Playbook
However, even as higher bond yields are leading to losses this year (as bond prices decline inversely)there is now potentially a window for unique opportunities for bond investors to plant their feet, buy newly issued higher yielding paper and hold it.
The recent rise in interest rates means investors buying bonds presently will receive higher yields, explains Bill Merz, head of capital markets research at U.S. Bank Wealth Management.
“We’re putting greater emphasis on core bond holdings,” Merz said.
Attractive categories include high-quality, investment-grade taxable and municipal bonds as well as short-term U.S. Treasury investments.
The latter is a strategyto manage overall risk exposure should interest rates continue to rise in the near term, Merz said.
What the Heck Just Happened?
Looking forward to the potential for bonds toeventually outperform is a worthwhile exercise if only to help mute negative thoughts surrounding the atrocious performance fixed-income portfolios have delivered so far this year.
Whatever happened to bonds being an anchor to windward?
Where is that old reliable buffer zone against painful stock market corrections?
Well, interest rates moved higher, faster, in an unprecedented fashion, producing a period of central-banker-wroughtfinancial marketsdisruption.
British government bonds most notably suffered enormous losses to the point where the Bank of England was forced to intervene as abuyer of last resort, in part to stave off a vicious cycle damaging the health of
UK pension schemes heavily allocated to fixed-income, according to Reuters.
U.S. investors are enduring historically dismal fixed-income performance.
Going back to 1977, bonds have tanked only five times, per the annual returns of the Bloomberg U.S. Aggregate Index.
As Forbes.com recently pointed out, the worst of those prior one-year periods was 1994. That year, the core bond index fell 2.9% in a global sell-off that began, naturally, after the Fed hiked rates.
At of the end of the third quarter of 2022, the bond index was down 11%.
Bonds haven't experienced a double-digit percentage decline since 1931 when they fell 15%, according to corporate bond data compiled and analyzed by New York University, per The New York Times.
Tide Could Turn
It's unclear when rates will stop rising.Wall Street is betting on a 0.75% hike in November and core inflation is apparently not slowing, based on statistics as of mid-October of 2022.
According to Bankrate.com, economists are forecasting a peak Fed-controlled interest rate of 4.75% next year and that would be in line with what the Fed itself has telegraphed by way of official statements released into the public record.
Inflation has now stubbornly lingered for much longer than any Fed official initially expected, Bankrate said, pointing out that this year’sthreepercentage points’ worth of rate hikes—in just a six-month span—represents the fastest rate-hiking pace since the early 1980s.
Back then, the Fed hiked rates from 14% to about 20%.
Bond investors will need patience to reap benefits when interest rates finally peak and, presumably, eventually, shift direction.
Most bond investors can expect to benefit ifthey can ride out this upheaval and hold onto their bonds, whether owned individually or in diversified funds, experts have said.
An environment devoid of extended bull market runs will mean that "the math from the compounding of dividends and income off of bonds will play a greater role in portfolio returns, according to Morningstar.
Wei Li, global chief investment strategist at BlackRock, told Morningstar that investors will need to wait for the Fed to hold rates steady, or even start cutting them, before Treasury bonds could turn positive.
In a bullmarket, the bulk of returns come from price appreciation, Morningstar said. But in choppier markets, income generated by investments plays a greater role in returns.“It’s important to take advantage of compounding and stay invested,” Li said.
Looking ahead to 2023, as Fortune recently asserted, there’s a genuinecase to be made for ramping up allocations to bonds —inexpensive, paying higher interest and, after a historic slump,very likely bound to recover.