The bargain that investors make with bonds is clear: in exchange for holding the most boring financial asset on the planet, they’ll receive slow, steady, but positive investment returns to cushion their far more exciting, but unreliable stocks. This year the agreement has been breached: bond prices have fallen alongside stocks as central banks raise interest rates to dampen inflation. How worried should investors be about this development and what, if anything, should they do about it?
To get at these questions, here are some answers to a few others:
How bad are the recent bond declines?
The Bloomberg US Aggregate Bond Index, a mix of U.S. government, corporate, and mortgage-backed securities with maturities of at least one year, is down almost 9% year to date.
Within that aggregate, there is a range of year-to-date declines, starting at -3.01% for short-term U.S. treasury bonds and extending to -21.25% for 30-year treasury bonds. Intermediate U.S. corporate bonds are down -12.94% for the year, and high-yield (aka “junk”) corporate bonds have declined -13.42%.
A comparative bright spot in the bond market is short-term Treasury inflation-protected bonds, which are down -1.40%.
There’s no good way to sugarcoat these declines, but they do underscore the importance of paying attention to bond maturities and credit quality for investors wanting to hedge stocks. Historically, as now, sticking with shorter maturities and higher credit quality has worked best.
What’s causing the bond declines?
In short, high inflation and efforts by central banks to tame it by raising interest rates. Both the magnitude and speed of recent Federal Reserve rate increases have been breathtaking. The Fed raised rates last month 0.75% - the highest rate increase since 1994 when it raised rates six times - and the Fed just raised rates another 0.75% this week.
When interest rates rise, bond prices fall, so that existing bonds can compete with new bonds issued at higher rates.
At least there’s no mystery to decipher here.
How unusual is the current situation with bonds?
It’s highly unusual. Since 1980, U.S. bonds have only had negative returns in four years: 1994, 1999, 2013, and 2021. The closest parallel to today, though, is the early 1980’s. Why? Because then as now, inflation was through the roof, which meant the after-inflation, or “real” returns of bonds was even worse than they looked.
You can see both the “nominal” and “real” returns of bonds in the chart below.
| Bloomberg Aggregate Bond Index | Inflation | After-Inflation Return | |
|---|---|---|---|
| 1980 | 2.71% | 13.50% | -9.51% |
| 2021 | -1.50% | 4.70% | -5.92% |
| 1994 | -2.92% | 2.60% | -5.38% |
| 1981 | 6.25% | 10.30% | -3.67% |
| 2013 | -2.02% | 1.50% | -3.47% |
| 1999 | -0.82% | 2.20% | -2.95% |
| 2018 | 0.01% | 2.40% | -2.33% |
| 2005 | 2.06% | 3.40% | -1.30% |
| 1987 | 2.76% | 3.70% | -0.91% |
Presumably, the Federal Reserve is raising interest rates so quickly now to avoid languishing in a 1980’s economic climate.
Should we be considering other ways to hedge our stocks?
This is the perennial question and one that we explored in 2019, during the halcyon days preceding the global pandemic. Portfolio Hedging - Can You Have Your Cake And Eat It, Too? As we noted then,
Most hedges cost money to purchase, which eats into investment gains. The best hedges come with the highest price tags, and prices surge like car-share rides during rush hour when markets become volatile and you most want protection.
Moreover, many hedges fail even to work as expected, which imposes a double-whammy on investment returns. We’ve seen that once again with precious metals such as gold this year. With surging inflation, “many expect gold to bolster their portfolios.” Gold Prices Hit by Renewed Bets on Higher Yields and Stronger Dollar. Indeed, inflation protection is the primary rationale many investors cite for holding precious metals. Yet, they’ve fallen 6.5% year to date, alongside stocks.
Cryptocurrencies such as bitcoin were also touted as a good inflation hedge, but have performed worse than most stocks this year, with bitcoin down a whopping 38% year to date at the end of June. Bitcoin just had its worst month on record
Finally, as we noted, “A hedge can be wonderful protection during a severe market downturn, but most of the time the stock market isn’t in one.”
Why not just sit this one out and go to cash for a while?
This injects a whole new set of risks. For starters, you have to get two decisions right — when to get out and when to get back in — and the markets move too quickly for most investors, even institutional ones, to profit from a “tactical” strategy.
As a recent Morningstar analysis noted, 2022 should have been the year when tactical managers, who are free to go anywhere with their portfolios, should have shined. Instead, they’ve fallen right alongside other strategic managers holding more vanilla stock-bond portfolios. (Have Tactical Asset Allocation Funds Earned Their Keep?)
Worse:
Tactical funds have been more likely to bite the dust and go out of business than their fund brethren.
During the more normal times that characterize markets over the long term, tactical funds have trailed other types of managers significantly.
In other words, contrary to claims of machine-learning algorithms, superior trading strategies, and other supposed competitive advantages, the track record of tactical managers suggests that their promises of protection remain illusory at best.
Okay, if we continue to hold bonds, what should we expect to happen next?
Intuitively, the future path of the bond market would seem to be easier to predict than the stock market. After all, we’re dealing with terms of years and interest rates, not inventing a new technology or going to Mars, right? However, this rarely seems to be the case.
In October 2017, for example, the chief investment strategist at a major investment firm stated in the New York Times,
"It’s inescapable,” said Scott Clemons, chief investment strategist at Brown Brothers Harriman. “At their current prices, bonds can’t help as much in a stock downturn. And the likelihood is that in the next few years, bond returns won’t be very good, either.”
The following year, however, the U.S. aggregate bond market was the second-highest performing asset class after the bottom fell out of the stock market. In 2019, bonds earned 8.72%, and in 2020, 7.51%, before declining 1.54% in 2021.
One lesson here is how important it is to look beyond the present year when making investment decisions. Often, expanding the lens reveals that while times may be tough right now for investors, over the longer term, they’ve benefitted from remaining exposed to the capital markets and resisting the temptation to exit from time to time when assets become volatile. Even with the recent declines, the Bloomberg US Aggregate Bond Index is still up over 16% over the last decade.
While we can’t say what happens next in the short term with bonds, today’s higher interest rates mean higher income for investors going forward. This, in turn, should increase the odds that bonds will once again serve as an effective hedge for stocks.