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Investors who typically turn to bonds as a safe haven during times of turmoil have been sorely disappointed recently. The 10-year U.S. Treasury bond, generally considered one of the safest assets in the world, fell nearly 18% in 2022, the biggest decline in history. This debacle comes on the heels of a 4.4% decline in 2021, with only a late December rebound preventing the stock from losing three straight for the second time in history. This is certainly not something conservative investors agreed with.
The dismal performance of the bond market is due to the Federal Reserve’s aggressive interest rate hikes aimed at curbing inflation, a policy that is expected to keep prices in check while avoiding significant damage to the labor market. has been extremely successful. But the drug has side effects, such as sudden weight loss in bond portfolios, leading many investors and even some advisors to avoid bonds and declare an end to the traditional 60/40 stock/bond allocation. reached. It’s time to buy bonds.
A bond is an investment security that represents partial ownership of a loan to a corporation, state, local government, or government, including the U.S. Treasury. The term fixed income is used because most bonds pay interest to their holders periodically at an interest rate that was traditionally fixed at the time of issue (although some bonds feature variable interest rates) . The face value is repaid to the investor at maturity, and the repayment period can range from a few days to more than 30 years. Investors can buy new bonds at the time of issuance or buy and sell them in a robust secondary market where prices are determined by a variety of factors, including interest rate levels, inflation, and changes in the issuer’s creditworthiness.
Broadly speaking, bonds serve two important roles in a balanced investment portfolio. Regular interest payments provide a steady income and, if held to maturity, they are relatively safe, acting as a ballast to reduce overall volatility during periods of stock market turmoil. The unprecedented failure of bonds as a stabilizer in 2022 can be easily explained in economic terms, but the fact that bonds lost money and failed in their role as an anchor has made it difficult for the situation to improve. At some point, many investors turned away.
To understand why the outlook for bonds is brighter than it has been for a generation, you need to understand the risks of bond investing. Credit risk is the probability that an issuer will default and be unable to repay its debt in full and on time. This is generally considered zero for U.S. government bonds and very small for highly rated corporations and municipalities. Maturity risk involves commitment with a long-term holding period, while reinvestment risk refers to the possibility of having to settle for a lower yield when a more attractive bond matures. .
Interest rate risk is central to understanding recent challenges and current opportunities. Recall that most bonds are issued with a specified interest rate, and that interest rate remains fixed throughout their life. For example, over the long-term period from 1985 to 2012, lower economy-wide interest rates led to higher bond prices in the secondary market. This makes sense since the value of a 10-year Treasury bond issued in 1985 that pays a steady 12% interest, while a new Treasury bond issued in 1990 pays just 8% interest.
Fast forward to 2022. Inflation rose rapidly in the aftermath of the pandemic and remains high, reaching 9.1% in June, its highest level in 40 years. In response, the Fed launched an aggressive interest rate hike campaign aimed at bringing inflation back to its 2% target.
In this event, the Fed’s benchmark interest rate jumped from 0.25% to 5.5%, a relative increase of 2,100%, making it the steepest and largest rate hike to date. Recall from the 1985 example that bond prices rose as interest rates fell. Investors now face the opposite situation. That means rising interest rates will cause bond prices to plummet in his 2022. However, interest rates are likely to have plateaued now and could start to fall later this year. The Fed expects inflation to rise further and the labor market to begin to soften. This presents an attractive opportunity for bonds as investors become increasingly pessimistic about them.
As inflation continues to decline, real yields (after inflation) are becoming more attractive for the first time in a while. Investors may want to focus on higher quality corporate bonds, U.S. government bonds, and agency mortgage-backed securities for a relatively safe and attractive source of income.
Additionally, households are sitting on a record $16 trillion pile of cash and are chronically underallocated to bonds. As BlackRock noted in a December note, this move would amount to more than $4 trillion in bond purchases if investors simply adjusted their bond holdings from 6% of financial assets to the historical average of 8%. This will support the rise in bond prices. In addition to that, attracting interest income that could look very attractive during the next stock market reset as interest rates are likely to fall in the coming years, a good example of capital gains can be made.
Goldman Sachs has declared 2024 the “Year of Bonds” in recognition of the favorable environment associated with interest rate normalization. Given the uncertainty of the upcoming election season, it may be a good time to support independent candidates. Vote for the bond in 24 years.
Christopher A. Hopkins, a certified financial analyst, is the co-founder of Apogee Wealth Advisors.
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