Bonds have always had a very important role in portfolio construction. While most investors think the reason for that is the income they provide, the more crucial element is the ballast that they offer to dampen volatility of an overall portfolio. Because they are less volatile than equities, and tend to move in the opposite direction of equites, they dampen the swings, allowing investors to stay the course. For instance, when stocks fell 50 percent during the Great Financial Crises, bonds actually rose 15 percent. A portfolio comprised of a 50/50 mix of stocks and bonds was therefore only down 19 percent. That’s the free lunch of diversification.
Not in 2022.
And for a few reasons.
First, rates were as low as they could go. Once you get to 0 percent, your upside to bond prices is gone (economic textbooks will have to be rewritten as interest rates did go negative in some parts of the world the past few years-but not in the U.S.)
Secondly, the Treasury issued massive amounts of bonds to finance the myriad of stimulus programs in response to the pandemic. From 1980 to 2019, the federal debt increased at an annual average rate of 5.6 percent. In 2020, it increased 18 percent compared with the year before as federal COVID-19 spending peaked. There are a lot more bonds that need to be sold, and to attract buyers you need higher rates.
Lastly, I don’t need to tell anyone that inflation is back in a big way. Inflation has a particularly negative effect on bonds because it erodes purchasing power. Bonds offer a fixed payment over time, and if those future payments have less spending power because prices are going up, investors will demand higher rates to be compensated for that.
So now we are in a negative feedback loop. It is because interest rates are going up that bond prices are falling. And stocks are falling because higher rates remove liquidity, which causes stock prices to fall. As bonds fall, they become more attractive for investors because the return is higher, and it is deemed less risky than stocks.
TINA (there is no alternative) has been the lament, since the financial crises really, that because bonds were paying so little investors had little choice but to up their allocation to equities to get some kind of return. As painful as 2022 has been, having rates rise to levels that really do provide a steady, positive return is welcome.
Just a side note from looking at the chart. I was working on the bond desk at HSBC in 1994, the now dethroned year of what was called the great bond massacre. It looks quaint in relation to what we’re experiencing now. In a case of history repeating, it began when the Fed surprised the market with an interest rate increase in response to a rise in inflation. The big difference between then and now however is the overall level of rates. 1994 ended with the benchmark 10 year bond at 7.8 percent. A 3 percent loss for the year would be recovered by interest payments in less than 6 months. Now, the 10 year is under 4 percent, so multiple years to be made whole. For reference, the Dow Jones finished at 3834.