It didn’t matter much what you owned; the first quarter was off to a rough start. Global stocks declined 5.4% while the broad bond market fell 5.9%. This quarter’s selloff was the worst performance for bonds in over 40 years.
With bonds and stocks down, a blended account of stocks and bonds offered little to feel good about and even less diversification.
Commodities were an exception and one of the few assets that gained in the quarter (and gained they did!). Russian sanctions shocked the global market for oil and gas, adding further fuel to inflation pressures. But while the performance of commodities this quarter was noteworthy, commodity prices are still below their 10-year peak. If you had bought and held a basket of commodities (measured by the Bloomberg Commodity Index) ten years ago, you would still be down over 14%.
The sudden rise in yields has been nothing short of remarkable. The yield on the 10-Year Treasury now stands at 2.6%, 1.9% higher than it was in June of 2020, and stands at the highest level since the pandemic began.
Rising yields mean lower bond prices, and this price decline has been unprecedented in the modern history of the bond market. The total return of the Bloomberg US Treasury Index has declined over 10% from June of 2020. That is the largest peak-to-trough decline on record since the inception of the index in 1973.
For perspective, the peak-to-trough decline in the bond bear market of the 1980s was only 7.4%. The 80s experience ultimately was a combination of several bad drawdowns as the bond market wrestled with Paul Volker’s strategy of targeting the money supply directly, leading to more fluctuations in interest rates.
The current inflation situation, while frustratingly persistent, is not as bad as it was in the early 80s when inflation reached 15%, and current Fed Chair, Jay Powell, is not Paul Volker. So, it’s surprising that an index of Treasuries bonds is currently in a worse drawdown. Basic bond math is the culprit. Over time, the average maturity of Treasuries has increased as the Treasury issued more long-term debt. More long-term debt, combined with less yield, was the kindling ready to ignite.
The Federal Reserve provided the spark. The Fed’s own projections suggest they will increase the Fed Funds Rate to 1.875% by the end of the year, reaching 2.75% by the end of 2023. The market has priced in an even faster pace of hiking, expecting the Fed Funds Rate to reach 2.5% by the end of the year and surpass 3% in 2023. So, the market has already done the Fed’s work and some, baking in the fastest pace of rate hikes since 1994.
All this has been difficult for bond investors and the bonds in a balanced portfolio. But set aside the doomsday rhetoric, bonds are not dead. High-quality bonds are a key component of a balanced portfolio. Treasuries serve as insurance in a portfolio; there is likely a time you will be glad you have them. They tend to do well when other assets suffer. Higher yields now suggest this insurance is cheaper than it has been.
What It All Means
We believe there are ways to help to mitigate the pain in bonds, but it’s not a good idea to avoid it all together. First, manage interest rate risk. The risks in a bond index, such as the Bloomberg US Treasury Index or the broader Bloomberg Aggregate Bond Index, can vary with issuance trends and other factors. Instead, we believe interest rate risk should be more targeted. This helps avoid compositional changes that may stealthily add duration to a portfolio. Second, look to other sectors in the bond market to help diversify the risks in a bond portfolio, but don’t go overboard. TIPS have performed well as inflation has exceeded expectations. Corporate bonds and bonds secured by mortgages, while riskier, can help dampen drawdowns when interest rates rise. Finally, while the stock and bond relationship does not hold all the time, stocks can also dampen the poor returns in bonds. Since Treasuries entered this decline in July of 2020, a hypothetical portfolio of 60% global stocks and 40% broad US bonds is up 16% cumulatively.
No one knows with certainty what the future will hold. Often, the best performance occurs when the proverbial towel is thrown in. The sentiment for bonds certainly feels that way.
For a while now, investors would cite the mantra, “there is no alternative” to owning stocks or TINA for short. Now with higher yields, at least the alternatives look a little better. The risk and return of bonds are unlikely to match equities, but the paltry returns of two years ago are gone (for now). That means reinvestment and new cash now offer better prospects.
Contact us at 865-584-1850 or info@proffittgoodson.com