Like I wrote last week, so far during 2022 bonds have generated large negative returns. Bonds are supposed to be less risky alternatives to stocks, so what goes? Following is a brief discussion.
Bonds are financial obligations of a legal entity, either a government (e.g., the U.S.), a corporation (e.g., Verizon), or some other structure. In the most basic form, they are analogous to a bank certificate of deposit in that they have a fixed principal amount upon which interest is paid over a set term. In bond parlance, the par value of a bond earns a coupon rate that is accrued and paid periodically over a set term.
For a bond that pays a fixed 3% coupon on a fixed par value for a term of 10 years to yield 3%, any change in the general rate of interest will impact the value of the bond; either up or down! A bond yield has two component parts: the risk-free rate (e.g., the U.S. treasury yield) and a spread over the risk-free rate termed the “credit spread”. Since the coupon is fixed, any increase/decrease in the general level of rates will cause the value of the bond to go down/up, so that the obligation continues to offer a yield that is competitive with the general market. Complicating things further, if risk-free rates are rising AND the bond is issued by a corporation with a weakening financial condition, the underlying credit spread (as a proxy for risk) would widen (i.e., go up) compounding the rate increase so that the bond value would go down ever further. This is what we have seen happen so far this year, per the chart below.
As seen from the above chart, the 10-year constant maturity U.S. Treasury (the red line) started the year at a yield of 1.52% while the credit spread for a common investment grade bond index (the blue line) was a tame 0.98% implying a total yield for an average corporate bond at 2.50%. During the year the 10-year treasury rate trended higher increasing by 1.31% to peak recently at 2.83% while credit spreads similarly increased by 0.28% to 1.26% implying a total increase in yields of a whopping 1.59% and a total corporate bond yield of 4.09%! Historically, this is a large jump in rates!
Looking over our shoulder, it is easy to decipher the cause; a hawkish Fed tightening monetary conditions to help slow down heightened inflation and cool down an economy that may be overheating. Other factors like the Russia/Ukraine conflict, persistent supply chain issues, and technical aspects also had an impact. Higher interest rates caused the value of bonds to decline; in fact, investment grade corporate bonds (LQD) with a duration of 8.9 years are down -12.7% year-to-date through April 14, 2022. Correspondingly, U.S. equities (IVV) are down LESS at only -7.5% over the same time horizon, but other diversifying equities like small- and mid-cap, international developed and emerging market equities are down more.
The Fed has telegraphed that more monetary tightening and rate increases are in the plan, depending upon how things develop over the near-term horizon, so more pain could be in store. For clients with a long time horizon and higher risk tolerance, D&A has been underweighting bond allocations by up to 10% over the past year and on a narrow basis this was the right thing to do. No one knows how the future will emerge, but sticking with a long-term strategy to achieve your goals is still the prudent thing to do.