Bonds are often touted as being a safer asset to stocks, for a variety of reasons: it is principal guaranteed and bond holders are ranked higher than shareholders should a liquidation happens.
The principal guarantee is an oversold proposition because this only applies if the borrower is able to stay afloat throughout the bond tenure and repay at maturity. Bondholders have experienced rude shocks during crises whereby the borrowers go belly up. Some were lucky to get the bonds restructured under new terms, else they got nothing back.
Moreover, principal guarantee doesn’t mean that the bond price stays stagnant throughout the tenure. The only bond that does it is Singapore Savings Bonds. Every other bond would see its price fluctuate due to some factors such as changes in interest rate or perceived credit risk.
Bond prices move in the opposite direction of the interest rate. The Fed has announced rate hikes and it is no surprise that US bond prices would fall. And yes, they have been falling.
Here are some price performances of various US government bond ETFs since the start of 2022,
1-3y (SHY) -3%
3-7y (IEI) -5%
7-10y (IEF) -7%
10-20y (TLH) -9%
20+y (TLT) -10%
You might think that these drops aren’t as scary as stocks. But these are large relative to the yields that these bonds are giving – e.g. if you bought a US govt 3y bond at the start of 2022, you got a yield of about 1%. By Mar you lost 3 years worth of yield. Of course, you can hold till maturity to get back your principal but the opportunity risk exists because the yield has jumped to 2.6% now (vs your 1% interest rate) and maybe rising even more within these few years.
The longer term bonds are even riskier because they are more sensitive to interest rate changes. Even though the 20+y bond ETF has declined 10%, more than the other tenures, it hasn’t seen the worst of times yet. This is because the increase in rates are more prominent for bonds with tenure of between 1y and 5y at the moment.
The US yield curve is hence slightly inverted now and this usually spells a pending economic recession.
Let’s paint a few scenarios to see the impact.
If inflation dominates and the Fed focuses on taming it, expect interest rate to go up faster and bond prices to fall even more.
If economic slowdown dominates and the Fed slows the rate hikes, bond prices should hold steady.
If it is a stagflation (inflation + economic slowdown), bonds may have mixed performances, depending on the Fed’s actions. If they cut rates to help with growth, bonds may do better on a nominal basis but the real return can be much lower due to inflation.
But why should investors care?
Modern Portfolio Theory has been used to construct investment portfolios for the majority. The 60% stocks and 40% bonds portfolio being the most classic. It was said that stocks and bonds go in opposite directions and hence rebalancing when they zig and zag would produce capital gains and lower the volatility of a portfolio.
Given the low interest rate environment and strong economic growth, stocks and bonds have been going up in tandem in the last decade. This benefited the 60-40 portfolio greatly.
But it is facing a double whammy now – both stock and bond prices have been falling at the same time as the rates went the other way. This diversification concept of stocks and bonds may not work during this period and we don’t know how long this situation will last. Bonds (especially long term ones) may be as risky as stocks at this point in time.
