The Perfect Storm
I probably do not need to tell you that this has been a very difficult year for bond holders and investors as a whole. In fact, the last time we have seen the bond market decline this much was back in 1994, nearly 30 years ago.
Many of you have never experienced anything but a secular (long-term) bull market for bonds. Remember, when interest rates decline, bond prices rise. Unfortunately, as shown in the graphic at the upper right, it also works in the inverse – when rates rise, bond prices decline. And the fact that rates have been rising is what has driven our prices down in 2022.
As you can see from the chart (below, right), interest rates have effectively declined from 15% at their peak in the early 1980’s to the recent lows near 2%. It is the reversal of this near 40-year downtrend that has caught the average bond holder off guard. But should it?
It is at times like this – when the bond market is at a crossroads as to whether rates continue higher or if the world’s broader economic issues reverse rates lower – that we need to remember why we own bonds in the first place.
In our work, we utilize bonds to help protect capital, provide some income AND to mature when we need that liquidity. Our definition means that we will most often buy individual bonds (as opposed to using bond mutual funds, exchange traded funds aka ETFs or other “products”).
I want to address the difference between owning individual bonds and owning a bond “proxy” – ETFs or mutuals funds, for example.
Individual bonds can deliver fixed (known) results regardless of the market events, economy or interest rates. Bond proxies cannot do the same as they do not have the maturity to provide the known exit from the investment.
For those of you who have been into our Boise office, you know we love to use the chalkboard wall to illustrate a concept. In the absence of our chalkboard, I have drawn the distinction between individual bonds and bond proxies below.
When you hold and individual bond to maturity (top graphic) – regardless of interest rate changes, supply/demand changes, headline news, price fluctuations – your cash flow is known, your income is fixed and your face value is returned at maturity.
When you hold a bond proxy (bottom graphic) – interest rate changes, supply/demand changes and headline news all impact (positively or negatively) prices and yields. And the biggest factor is that you have no maturity date that fixes the amount you will receive at the end – making the proxy even more risky as we have no control over the direction of future interest rates (similar or lower rates are required to exit the proxy with your principal or a gain).
One last important point – the impact of duration. The length of the maturity on a fixed income investment is directly correlated to the impact of interest rates on that investment. The longer the maturity the more a bond price will generally vary. As you can see from the chart below, a 1% rise in rates causes a 1.9% decline in price on a treasury bond that matures in two years. That same 1% rise in rates causes a 30-year treasury to decline by 18.9%!
The following is an excerpt from the most recent edition of Raymond James’ Fixed Income Quarterly:
“So what does the future have to hold for fixed income investors? Well, that may depend on the way your bonds are purchased. If your fixed income allocation consists of total return packaged products with no maturity date, it has likely been a rough ride so far this year. As yields have surged higher, prices have fallen sharply, leading to poor total return performance across most of the fixed income landscape. Without a stated maturity date and price, returns are dependent on price movement. When prices fall, performance suffers. Yet from the perspective of an income investor with individual bonds, interim price movement does not have that dramatic negative effect. No matter how far the price of bonds fall, when holding the bond to maturity: the coupon cash flow doesn’t change, the maturity date doesn’t change, the maturity value doesn’t change, and the income earned doesn’t change.”–Raymond James Fixed Income Quarterly
Remember: It’s not always about the yield, it’s about wealth preservation
Some areas of opportunity to consider:
Concerned about rates rising further – you may want to consider shortening your maturities.
Concerned about a recession & rates turning back down – you may wish to extend out further instead of staying short.
Need cash flow – There are many investments that can provide cash flow. Given the risk of long dated bonds, this may not be the only place to find cash flow. Did you know that over five-year rolling periods – stocks and bonds have nearly the same amount of downside risk1? Most people do not understand the impact time has on helping to reduce risk to stock investing.
If we have not had an opportunity to do a full portfolio review and help map your investments to your individual goals, we would love to set a meeting with you to do so. Please reach out to us with any questions or concerns.
Best regards,
Josh J. Miles, BFA®, CPWA®
Managing Director – Wealth Management
Financial Advisor
NOTES:
- Source: Invesco. Compelling wealth management conversations. 12.31.2020 Report compares the S&P 500 to the Barclays Aggregate Bond Index from 1950 – 2020. The worst 5-year period for stocks was -3% per year and for bonds was -2% per year.
All expressions of opinion are those of Josh J. Miles and not necessarily those of Raymond James and are subject to change. Economic and market conditions are subject to change. The S&P 500 is an unmanaged index of 500 widely held stocks. An investment cannot be made in this index. Investing involves risk and investors may incur a profit or a loss regardless of strategy selected.
There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. This material is being provided for information purposes only. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any hypothetical examples are for illustration purposes only and don’t represent an actual investment.
Bond Prices and yields are subject to change based upon market conditions and availability. If bonds are sold prior to maturity, you may receive more or less than your initial investment. Holding bonds to term allows redemption at par value. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise.
