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While inflation has retreated significantly from the highs witnessed in 2022, the bond market is again experiencing record levels of volatility. While both equities and bonds posted solid returns in the first half of the year, bonds have since given up most of those gains and left many wondering why.
There are many reasons, but the main one is the Federal Reserve. After keeping interest rates at record lows for nearly a decade, the Federal Reserve flipped the script by aggressively raising rates at the start of last year, and it hasn’t looked back. From all indications, they may raise rates a couple more times this year while continuing their fight against inflation.
The good news is inflation has subsided by every metric. However, the Fed seems keen on not taking chances of allowing it to spike again, thus their plan of additional rate hikes.
Whether these hikes can continue without causing structural economic damage remains to be seen, but one thing is certain: Bond market volatility is unlikely to subside until the Fed pumps the brakes.
As I’ve said before, the Fed has an extremely difficult job, but this case appears to be a classic one of overcompensating for past mistakes. They were far too late to raise rates in 2021 when it was clear inflation was not transitory and are now trying to make up for it by aggressively raising rates.
In the end, the economic data will largely dictate how things go from here. If economic data softens, the Fed will have no choice but to pause and start conserving rate cuts come 2024. Their goal is to slow economic growth without sending it into a recession, but moving interest rates higher or lower can only do so much.
Let’s take a closer look at a few key barometers as of this writing:
Fed funds rate: Sits at ~5.25%, the highest level since 2007.
One-year CD rates: Near an 11-year high of ~5.2%.
30-year mortgage rates: Fluctuating between 7% and 8%. Haven’t been this high since 2002.
Perhaps the most stunning element is the pace of these increases. At the start of last year, a 30-year mortgage was ~3.15% and a one-year CD yielded ~1%.
At this point, you’re likely asking yourself: “How can this be a bad thing for bonds as higher rates mean higher yields?” The answer is things are never that simple.
Generally speaking, higher interest rates are better for bonds as they earn a higher yield (income). The issue stems from a bond’s sensitivity to interest rates, a term called duration. Depending on the bond you own, duration can be your friend or your enemy. Let’s take a look at an example:
Brian’s bond portfolio has a duration of 5. If interest rates increase by 1%, the value of Brian’s bonds will decrease by 5%. Likewise, if rates decrease by 1%, the value will increase by 5%.
A bond has two components: principal and interest income. Barring the entity defaulting, you will receive the principal at maturity while collecting interest along the way. With interest rates near zero for much of the past decade, investors were rewarded for investing in long-duration bonds since they paid the highest interest and rising rates were not a real threat.
Bringing this back to the present, investors feel skittish about holding bonds with intermediate- to long-term durations because they fear that the Federal Reserve will keep raising rates. In this case, owning cash, CDs, or short-duration bonds seems logical, right? While this strategy won’t hurt you, it ignores the tremendous opportunity with many segments of the bond market.
The irony is most investors jump at the opportunity to buy the dip in the stock market but not with bonds. Why? In my opinion, bonds generally don’t “dip” much, so a decline like the one we have experienced has left people unsure of what to do.
Calculating a bond’s total return isn’t too difficult. The issue is the volatility that takes place from when you purchase the bond to when it matures.
As seen on the chart below, the U.S. Aggregate Bond Index has experienced a drawdown of at least 4% in each of the last four years, with a whopping 17% last year. In addition, both 2021 and 2022 ended with negative returns for the index, which had not happened in over 40 years!
If the index ends negatively this year, it will be the first time it will have posted three consecutive annual declines. While alarming, we have a good reason to be optimistic moving forward.
In a perfect world, interest rates gradually increase or decrease over time, limiting bond volatility. When interest rates spike from nearly 0% to 5% in a mere 14 months, some chaos should be expected.
The Federal Reserve’s target is to gradually bring the fed funds rate back down to 2% to 3%.
As seen on the chart below, many high-quality bonds now sport a yield to maturity of ~4.6% to 5.8%. While that may not wow anyone today, these returns are pretty much fixed over the next five to seven years, barring a massive spike in defaults.
When the Fed stops raising interest rates, the yield on short-term instruments (i.e., high-yield savings, CDs, and short-term bonds) will drift lower, while intermediate- to long-term bonds will sport a higher yield for an extended time.
The fact that investors can earn north of 5% on high-quality, low-risk bonds is incredible, considering that a few years ago, earning 1.5% to 3% was considered “good.”
I have a feeling about how this will go. Currently, most investors are avoiding all bonds with intermediate or long durations while they are on sale. Once rates stop rising, the chase will start, money will pour back into these exact bonds, and people will ask why they didn’t buy them sooner.
Investing is not easy. It becomes even harder when stocks and bonds experience whipsaw levels of volatility.
The bright side is this bond scenario rarely happens, but when it does, forward-looking returns become more attractive.
Discuss your situation with a fee-only financial advisor.