Bonds were pummeled in the first half of 2022, to say the least. No doubt, these are trying times for bond owners and conservative investors generally, since fixed income hasn’t typically experienced that type of price movement in many years. In fact, was one of the most volatile 6-month periods since the inception of the Bloomberg U.S. Aggregate Bond Index in 1976, back when it was known as the Lehman Agg.
Interest rates are unpredictable on an outright basis, not to mention navigating divergences between short-term and long-term rates. Recently, yields have stabilized, which may have potentially stopped the damage in the current cycle, but it might be useful to review future fixed income prospects through a few different scenarios.
‘Bear case’ (continued inflation, higher yields, lower prices). This assumes the Fed continues to battle inflationary forces from fiscal stimulus and pandemic supply disruptions that are perpetually weighing on the economy. Particularly, likely includes the Fed taking on an even more hawkish policy than already assumed (to 3.5% fed funds rate by Dec., for example). Due to the variety of influences, there is only so much monetary policy can do to battle inflation, with recent academic work at the San Francisco Fed reiterating that the current inflationary episode has been caused by roughly equal effects from each source. This was already assumed to some extent, but this provided more robustness to the analysis (and likely spurred by the Fed’s claim that it can’t solve all inflation problems through its tools solely). Nevertheless, high inflation could force continued rate hikes, rewarding cash and short-term bonds as opposed to long-term bonds. Even here, though, there’s a limit to this, as Volcker found in 1980-81—you can’t hike indefinitely without creating a recession. There is rising market uncertainty about the recession vs. ‘soft landing’ prospect right now.
‘Base case’ (more normalcy, stable yields, stable prices). A return to more typical conditions could mean a few additional months of higher inflation, but a peak and gradual calming over the next year. This is the path the Fed and many mainstream economists continue to see as the highest probability. It could also continue to coincide with some market volatility as investors speculate on the ‘when’ along with ‘how much’. The scenario is hinged upon a combination of inflation from fiscal stimulus spending continuing to decelerate (looking at data like M2 balances, etc.) and the improvement in supply/logistics conditions globally, both in China and potentially any improvement or workarounds for Ukraine/Russia output. More clarity on the geopolitics could provide better stability in rates across the curve.
‘Bull case’ (recession/deflation, lower yields, higher prices). If the Fed hikes too much and too fast, it could push the economy into recession. Or, a recession could be in the cards regardless, due to slowing economic activity and the natural end of the quick post-Covid cycle. The rising probability of recession is what financial markets seem to be pricing in most recently, as such a scenario has happened many times before. Most directly, this can be seen in the treasury yield curve’s steep positive slope from 3m to 2y, but flat to slight inversion from 2y to 30y. This implies the Fed raises rates to a certain point, but then stops somewhere around 3-4%, give or take—with long-term conditions and limited Fed balance sheet reductions putting a cap on further upward movement. Long-term bond yields are based on long-term conditions, such as expected inflation and secular GDP growth years from now. If recession becomes a base case, and inflation begins peaking, long-term bonds could actually fare well, in expectations for a reversal in Fed policy. (We’ve seen some limited examples of this in recent weeks.) A true recession and/or deflation could actually favor long-term bonds since rates could fall back, especially if Fed easing implied (even if hard to imagine now). Defaults would also be higher, so such a situation could reward higher-quality bonds less likely to have problems.
Long-term, rate levels will depend on the balance reached between long-term secular growth drivers, which continue to be held back by weak demographics (an aging population and far lower immigration, which decrease the size of the work force) and productivity trends that dampen inflation, including technology. From a national debt perspective, higher and rising interest rates create compounding challenges in servicing the already-large mountain of treasury debt. One might look at contained interest rates as being critical to the economy’s fundamental condition, but also national security (these things are discussed in military circles). This is not only an issue in the U.S., but globally—with emerging markets, ironically, in the best shape fundamentally in terms of debt loads.
Back to today, the good thing about bonds (especially investment-grade bonds where default risk is minimal, so defaults will be disregarded for now), is that the $100 par price is the ultimate end point upon a bond’s maturity. This is true regardless of price volatility based on changing yields that occurs over a bond’s life. Transactions before maturity, of course, can end up being based on current market price, which can change the gain/loss math on both individual bonds and funds/ETFs. While simplistic, holding a bond long enough will return an investor’s principal back. The eventual $100 par target of course limits upside, but also limits downside. This is in contrast to stocks where fundamental values are hinged to earnings, with unlimited upside but a downside of as low as zero, since they fall lower in the capital structure and feature less recourse and ability for asset recovery. This attribute is actually critical to the appeal of bonds as an investment and their place in a broader portfolio, but is easy to forget during times of poor short-term returns.
In short, holding to maturity can cancel out the ‘noise’ of price volatility. For a single bond, this is easy to view, but for a bond fund/ETF that holds a portfolio of bonds, this can be best thought of as tied to the portfolio’s duration. For this reason, duration has been a good proxy for an investor’s assumed holding period. The Bloomberg U.S. Aggregate currently has a duration of about 6.5 years, which implies an investor with that timeline or longer should be more insulated against near-term price volatility. Shorter-duration bond funds, such as the common 2-4 year area, have an even shorter period for price recovery, as do even shorter ultrashort funds and money market funds, etc.
The best predictor of future bond returns is the current yield, linked to the duration of the particular bond or fund. Now, short-term bonds offer yields just as high as those of long-term bonds, which is a positive attribute in a rising rate environment, but such situations don’t continue forever. Short-term bonds ‘reset’ faster, which can be a plus or a minus. The trade-off (2022 aside) is that long bonds have often been better diversifiers from equity market drawdowns, so abandoning them entirely can backfire if conditions reverse quickly. Markets are constantly looking months or quarters in advance, so bond (and stock) markets will have reacted long before actual economic change occurs, so recent past performance is not a great gauge for future prospects.