As we referenced in our quarterly letter and blogged about last month, it has been a difficult time in markets with lots of volatility and the usual inverse relationship between stocks and bonds missing with both in negative territory for the year. The causes of this are numerous, but the headline grabbers have been the Russian invasion of Ukraine, rising inflation and rising interest rates.
This phenomenon is rare in markets, though not unprecedented. In fact, the last instance was just in 2018 at a time when the Fed was also raising rates. While we expect stocks to move up and down through bear and bull market cycles, bonds, especially the short-intermediate term, higher quality variety we deploy in TAAG portfolios, tend to be less volatile. While that has proven true, with longer-term bonds significantly lower than their shorter duration counterparts, the overall bond market is still experiencing significant drawdowns.
Diversification hasn’t been a total loss. As I write this, the S&P 500 is down roughly 14% for the year while a global basket of stocks, depending on the fund, may only be down 8-10%. But looking closely at certain individual companies, especially big tech growth companies, you can find substantially more pain. For example, e-commerce giant Shopify and global giant Amazon are down more than 75% and 38%, respectively, from their 52-week highs as of this writing. Having exposure to value companies across the globe has significantly softened some of these significant losses.
The same is true in bonds, depending on strategy. While the overall US bond market is down more than 10% year to date, many shorter-term bond funds are down more in the 1-5% range. Still, with bonds adding to, not offsetting losses in the recent term, the question can rightly be asked, is this the time to bail out of or change our approach to bonds?
Most people invest in bonds in one of two ways. The first involves buying individual bonds directly. While not as complex as it may seem, it is not as easy to evaluate or purchase individual bonds as it is a stock, ETF or mutual fund. The attractive element of buying an individual bond is locking in a specific rate which, if there is a set income need over a set timeframe, can be a good thing.
A few of the many problems come when plans change. If circumstances change and cash is needed sooner than expected or if inflation runs high and the interest the bond is paying is insufficient, individual bonds can be problematic. Take our current environment as an example. If someone needed to sell an individual 10-year bond purchased back in early 2021 at a rate of around 1% today, when the 10-year Treasury is hovering around 3%, they’ll have to accept selling at a loss. In other words, they would be stuck with a decision to either accept the 1% interest for the remaining bond term or sell today at a steep discount, effectively deciding whether they want to lock in a loss today or know that the interest paid for the rest of the bond’s life may not cover rising costs.
This doesn’t even get into bond pricing which is not nearly as transparent as in equity markets and is a discussion for another day.
The second way to invest in bonds is through a mutual fund or ETF. These have their downsides, too. They fluctuate in price from day to day just like individual bonds, but not quite as much as an individual bond might. This is similar to concentration risk with individual stocks versus a diversified fund. The other downside is that that interest income from the funds will be more variable as the overall yield of the fund will fluctuate as bonds within the fund turnover.
On the other hand, in markets like we’re currently experiencing, while the price of the bond fund suffers as rates adjust, a bond fund or ETF is buying into new issues at new, higher rates on a consistent basis, allowing an investor to participate in higher rates immediately and, eventually, experience significant price recovery when rates inevitably move lower or the portfolio of bonds turns over to more attractive rates. In other words, there’s the opportunity for both price recovery and increased income assuming rates continue to rise or level off at some point.
It’s also important to consider the alternatives. Investors can increase exposure to stocks, but that means significantly increasing risk. They can hold cash, but in a high inflation environment, that means locking in the loss of purchasing power, potentially in dramatic fashion. One can also consider alternative investment solutions, but these come with plenty of their own risks typically including higher costs, reduced liquidity, etc.
There is no foolproof investment strategy, but at some point, something has to give. Inflation may cool which would give the Fed reason to slow rising rates and possibly give stocks the opportunity to rebound. Rising rates may also continue to push the market downward into recession for a while which could also give the Fed reason to pause rates or lower them again, bringing bond yields down and prices back up.
When and in what order those events might occur and how far the pendulum will swing with either stock or bond prices is anyone’s guess. As painful as it can be in the short-term, staying the course is almost always the best path forward.