Inflation has impacted the bond market and yields, but is now a good time to enter the bond market? Thursday, 25 August 2022
There are two major questions many investors are asking with regard to the bond market these days, and we’ll examine both in this episode. We’ll also discuss the impact of inflation, provide historical context, and share the Flourish Wealth Management approach to client portfolios within this context.
Hi everyone, Jay Pluimer here with Flourish Insights. As the director of investments at Flourish Wealth Management, I take pride in providing our clients, colleagues, and friends with resources and information that can help them make strategic and effective choices regarding their investments. If you’ve been enjoying the show, be sure to subscribe on Apple Podcasts, Spotify, Google Podcasts, or wherever you get your podcasts, so you’ll never miss an episode.
Today, we are discussing the state of the bond market while putting the bad performance from the first half of 2022 into context.
When interest rates go up, bond prices go down. The price impact can be particularly painful when bond yields are at historically low levels and can’t provide much of an offset. This has been the story for bond markets in 2022 as interest rates have risen at a staggering pace on the backs of high inflation expectations and aggressive interest rate hike policies from the Federal Reserve. It's important to note that although we will be focused on the US Bond Market in this episode, 40 countries are currently raising interest rates in efforts to fight high global inflation rates, meaning we are not alone with this problem and there is no place to hide from the bad environment.
Bond prices have been falling across the spectrum, hitting corporate and municipal bonds at the same time while causing the worst returns in over 40 years. As of June 30th, UltraShort Bonds had lost 3%, Short-Term Bonds dropped 7%, Core Bonds were down 10%, and High Yield Bonds were down over 14%. This is the first time since 1994 that stocks and bonds have both lost money at the same time. These dramatic losses raise a couple questions.
The first question is whether or not we are in a Bond Bear Market. We all know that a 20% drop in the Stock Market is the definition of a Bear Market for stocks, but there isn’t a similarly clear definition for bonds. Part of the reason we don’t have a definition for bonds is that they have been in a Bull Market for the past 40 years during a mostly declining interest rate environment, plus it’s extremely rare for bond investments to fall that much. If a 10% loss for long-term bonds and a 5% loss for core bonds define a bear market, then we have definitely exceeded those benchmarks.
The last broad-based bear market for bonds occurred from 1960-1981, during a period of high inflation in the US. The yield on a 10-year US Treasury rose from 3.9% to 15.8% during that time. Since bond prices fall when interest rates rise, we would expect the total return on the 10-year Treasury note to have been abysmal during that period. In fact, while annual returns ranged from -5.4% to 18.3%, the average annualized return during this period was 4% because as interest rates rose, income and principal payments could be reinvested at higher rates and offset the impact of price decreases.
The second question is whether or not now is a good time to buy into the bond market. We have been encouraging clients with cash on the sidelines to add stock exposure while the market is on sale by 20%, but we are not as optimistic about bonds at the moment. The first consideration is that the Federal Reserve is not done raising interest rates, so the yield curve could continue to be a headwind for bond investors. In addition, core and long-term bond rates have not moved up in tandem, with short-term rates leading to a slightly inverted yield curve, an environment that is not favorable for new investments. Although bond yields are higher now than 6 months ago, we could continue to see negative bond returns through the rest of the year. In addition, looking at real returns for bonds means calculating the current return minus inflation, meaning that a 3% return for bonds over the next 6 to 12 months has a negative real return of 6% when inflation is at 9%.
Our approach in client portfolios over the past few months has been to purchase short-term CDs, between 6 and 24 months, to capture moderate yields between 2.5% and 3.5% while protecting the principal of the investments. Staying short-term also maintains flexibility to buy higher yielding bonds in the future if the Fed continues to increase interest rates. We feel this provides a safe approach to capture positive bond yields to offset some of the damage from earlier in the year, but we will continue to closely monitor the bond markets for investment opportunities. Hopefully the next couple of years will be more favorable for bond investors so we can recover from historically bad bond market returns in 2022, understanding that bonds continue to be an important part of client portfolios because they reduce risk for a diversified portfolio while providing reliable income.
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