Bonds are typically the buffer against equity downturns in client portfolios. So far in 2022, that hasn’t been the case, with some bonds falling further than certain areas of the equity market. So, what is an investor to do?
First, let’s address why bonds are down this year.
Bond prices have an inverse relationship with interest rates. As interest rates go up, bond prices go down. Why? Imagine you own a $10,000 bond with a 2% coupon – you’d collect $200/year in income from that bond. Now, if interest rates rise and you can buy a newly issued bond at 3% (thus collecting $300/year in income), the value of the bond you currently own (that is paying $200/year) is now less. Why would someone pay you full price for it, right?
Now, let’s also remember that:
1) It’s extremely difficult to predict interest rates movements and
2) The market is forward-looking
First, on the predicting of interest rates.
The consensus in the market at the end of 2021 was for 3, maybe 4, quarter-point (0.25%) rate increases from the Fed which would’ve taken the Fed Funds rate to 1%. Those increases would stretch over the course of the year which is easy for the bond market to digest. So far, the Fed has only raised rates by 0.25% yet bonds have fallen much more than that increase would warrant. Why? Because of point #2 – markets are forward-looking. The Fed has admitted it is behind the curve on inflation and plans to raise rates more aggressively. The market is now pricing in faster and incrementally larger rate hikes with an eventual landing point (based on consensus) around 2.50% on the Fed Funds rate. So, while only one rate increase has happened, bond prices have reacted as if many more have already occurred.
What does this mean for bond investors?
First, much of the pain may have already happened so we need to look forward, not in the rearview mirror. The past stretch of rising rates was a surprise to the markets, but now markets are expecting more increases. It may turn out that the market has done a lot of the work for the Fed already and it won’t end up needing to hike rates as aggressively. It’s not necessarily true that further rate increases will spell bad news for bonds. If rates continue to increase, but below consensus, then bond prices would benefit. With a 50-50 chance of rates rising more or less than consensus, it’s better to own quality bonds across asset classes and maturities.
Additionally, higher yields equal greater interest income. Most of the return from bonds is derived from the income paid. Higher yields from here actually increase the long-term outlook for bond returns. So why abandon bonds now when the long-term outlook may have just improved? On the contrary, the more that bond yields rise (and prices fall), the more important it is for long-term investors to maintain a strategic allocation to bonds.
Then there’s the question, “Why not just sell my bonds and own cash?"
Again, we need to shift our mindset to a forward-looking view of the market. The market consensus is that rates will rise, and the prices of short, intermediate, and long-term issues already reflect that belief. Today's market prices for longer-term bonds already factor in investors' expectations for rising rates, which is why prices are lower. If that consensus view were to play out, there would be no advantage in moving to cash. That move would pay off only if longer-term yields were to rise more than expected. However, it's equally likely that yields will rise less than expected, in which case longer-term bonds would do better.
Finally, the Fed also needs to raise rates,
so they have room to reduce them during future economic disruptions. As we addressed earlier, bond prices move inversely to interest rates, so a decrease in rates to support a faltering economy would mean an increase in bond prices – adding a buffer against equities during the next recession, whenever that may occur.