The first (almost) three months of 2022 have not been kind to bonds. As a result we have had numerous calls from clients wondering what, if anything, should be done about the bond holdings in their portfolios.
Perhaps the best way to address this is to deal with the questions directly:
Why are my bond funds down in value?
There is a mathematical connection between the prevailing level of interest rates and bond prices. While the details are complex, it’s simplest to think of the relationship between prices and interest rates as a see-saw. When interest rates go down bond prices go up, and when interest rates go up bond prices go down. Remember this is a general guide, and the amount to which a bond goes up or down in value depends on many factors, including the type of bond (eg. government versus corporate), the term to maturity of the bond, and the amount to which the interest rates have changed at each term period from short term to 30 years.
I hear everyone is selling their bonds.
We hear this about stocks when the market is down as well. The global bond market is larger than the stock market, and sits at about $128 trillion. All of these bonds are owned by someone, so, as is the case with stocks, there are equal numbers of buyers and sellers. It just may be that the sellers are more eager to sell at any price, while buyers are more selective. In the case of bonds, the buyers set the price and therefore the yields that bonds provide. In many ways then, the bond market reflects the expectations of market participants about future inflation and economic growth, and establishes the “yield curve” (a line that plots the yields of bonds having equal credit quality but differing maturity dates). There are equal numbers of buyers and sellers.
Isn’t it safer to own individual bonds rather than bond funds? At least you know that when a bond matures you will get your money back.
To answer this I will quote Cliff Asness1. “Bond funds are just portfolios of bonds that are marked to market every day. How can they be worse than the sum of what they own? The option to hold a bond to maturity, and “get your money back”, is apparently greatly valued by many but is in reality valueless. The day interest rates go up the individual bonds fall in value just like the bond fund.” One of the other concerns is that “bond funds never mature”, whereas individual bonds do. That is true, but again only for individual bonds. If someone holds a laddered bond portfolio with a bond maturing every year, they would typically reinvest each year’s matured bond into another. So, in fact, the laddered bond “portfolio” doesn’t mature either.
In the end, whether you own a bond fund or a portfolio of laddered bonds, there is some risk in owning bonds. These risks may differ from the risks of investing in stocks, and in general result in lower volatility than the stock market experiences, but they can still result in negative returns for bonds over certain periods of time.
Why don’t we sell our bonds now and buy them back when interest rates peak?
Imagine this: you buy a rental property which provides monthly income for you. The purchase agreement allows you to sell the property back to the original owner at some point in the future at the same price you paid for it. If the property goes down in value, would you sell it, even if the monthly rent remained the same? Of course not, since you know you would get your money back just by waiting.
The same is true for bonds. Bonds are issued at par value price of $100 per bond and mature at the same par value at some point in the future (setting aside the risk of default for purposes of this discussion). Say a $100 bond has declined in value to $95 today. You know that all you need to do to recover your $100 investment is continue to hold that bond. So why would you sell it now? In fact, as each year passes and the bond gets closer to it’s maturity date, the returns “speed up”, since it continues to pay the same interest each year, but the bond’s price must get back to par by the redemption date.
Lastly, trying to time the highs and lows of interest rates can be tricky. While short term interest rates, controlled by central banks, are expected to go up numerous times this year, the potential movement in longer term rates is less clear.
Why don’t we sell our bonds now and replace them with stocks which should do better in a rising rate environment?
The decision to sell bonds and buy stocks should be based on asset allocation factors, and not predictions of how individual asset classes are expected to perform in the short term. If your current asset mix does not reflect your long term asset allocation strategy, then we would recommend adjusting the portfolio accordingly – a process known as rebalancing. However, if you are targeting an allocation of say 60% stocks and 40% bonds, and you already hold 60% in stocks, then we would not recommend increasing stock holdings just because of a prediction of poor bond market returns. That move would require taking on additional risk. In this situation the only appropriate replacement for bonds, from a risk mitigation standpoint, might be cash, and only if you are comfortable sacrificing income for safety of principal (inflation notwithstanding).
What can we expect from our bonds going forward?
It’s difficult to predict what will happen to bond prices in the next 6-12 months, as that will depend on how much the central banks raise the short term rates and what happens with inflation. However, there are a few things we can predict with some certainty:
- Bonds will continue to provide income which will help offset capital losses from rising rates and deliver positive returns over time.
- Reinvestment risk is positive for bond fund investors when interest rates are going up. What does that mean? Bond funds receive cash flows from a variety of sources – interest payments on the bonds they hold, bonds maturing within the portfolio, and new cash invested in the fund. In a rising rate environment all of these cash flows can be used to buy new, higher yielding bonds, meaning an increasing stream of income for bond fund investors.
- Bonds continue to provide stability to a portfolio, even after a rate hiking cycle. In fact, after a rate hiking cycle there can be an increased chance of an economic downturn which in turn can result in stock market declines. When stocks decline many investors seek the safety of government bonds, thereby pushing up prices and pushing down yields. For example:
We understand that investors are concerned seeing the value of the bond holdings decline. Our advice, as always, is stay the course, minimize diversifiable risks through asset allocation and security selection, control costs, and discuss any concerns with your CM Group advisor.