bond market

Busted Bonds

March 24, 2022

With all the turmoil in the world, no wonder we have seen stock market declines.  Stock markets had done so well for so long, and now you add a war on top of it, so it’s easy for our minds to justify the recent volatility.  But bonds aren’t so intuitive.  Bonds are supposed to help protect.  Yet, at a time when protection feels most needed, we have seen this from bonds:

Source: YCharts.  Data YTD through 3/21/22, tickers respectively above are AGG, MUB (intermediate term municipals), SUB (shorter-term municipals)

The bond market itself (represented by the AGG ETF above) is down almost 6% on the year.  Down?  Stocks are down; shouldn’t bonds be up?  What’s making this happen?  There are two main and related culprits: rising interest rates and inflation.  The war in Ukraine has further pushed an already heightened inflationary market, causing the Fed and bond markets to adjust rates up.  In the short-term, as interest rates go up, bond prices go down, which is what we’ve seen so far in 2022.  How can you protect against this?  Two options that keep risk in mind are using cash instead of bonds or using shorter-term bonds.  If you go to cash, we know the outcome.  No risk, but also no return and a known loss to inflation.  If you go shorter-term on bonds, you can see above instead of being down 6%; you’d only be down 2%.  An improvement, but is there a trade-off?

Source: YCharts.  Data from 1/1/2019 through 3/21/22, tickers respectively above are AGG, MUB, SUB

The answer is yes; there is a trade-off.  By reducing the term of your bonds, you’d feel better this year by losing less, but even with that “win,” you would have lost.  This is demonstrated above by what we’ve seen over the last three years; by being in short-term bonds, you would have given up over 1.4% per year in return.

We’ve been talking for years about the impact of lower interest rates on returns.  We were discussing that if bonds were able to return 2.5-3% per year, that would be an absolute success in a low-rate market.  What’s happened since?  See the chart above.  Even including the nearly 6% decline so far in 2022, the taxable bond index (AGG above) is up 2.34% per year, and the muni bond index (MUB) is up about 2.5%.  While the decline this year doesn’t feel great, it has brought returns back in line with expectations.

This reiterates how bonds get their return.  Over time, 90% or so of a bond’s return comes from the interest rate they pay.  Back to start 2019, the 10-year Treasury rate was at 2.67%, and bond returns ended up very close to that.  Coincidence?  Not so much.  During the day on March 22nd this year, the 10-year is 2.39%.  So, what should we expect out of a bond index?  Somewhere roughly around there, with the ability to do a little better than that with diversification to other areas of bonds.  However, we still remain in the spot of thinking 2.5-3% will be a great rate of return for bonds.  Does it feel great, especially given where inflation is at today?  No, but it’s ok and better than the alternatives of more risk or less return.

Source: BLS, FactSet, Federal Reserve, JP. Morgan Asset Management. Real 10-year Treasury yields are calculated as the daily Treasury yield less year-over-year core CPI inflation for that month. For the current month, we use the prior month’s core CPI figures until the latest data is available. Guide to the Markets-U.S. Data are as of March 16, 2022.

As seen by the gray line in the above chart, we are in a rare time, where real yields (actual interest rates minus inflation) are significantly negative.  But this is not the only time.  We have seen this before, and the market typically doesn’t stay in this paradigm for long.  Inflation will take some time to subside, but it will subside.  In the meantime, bonds are earning more interest than they were three months ago, which just makes them even stronger going forward.  Where from here?  If rates go down, expect to feel a little better about bonds this year but then earn a little less going forward.  If rates go up further, then more short-term pain is likely, but the gift of higher future returns comes with it.  If rates stay the same, then on a monthly basis, interest payments will keep filling up the hole created by the loss this year, so it feels a little bit better each month.