Let’s face it…
Investors have been absolutely punished for holding bonds these last few years. As an aggregate, the US bond market is down a whopping 15% annualized since the end of 2020. The Bond Market!
Now, we might expect that from a recessionary stock market, but not bonds. Over the last 50 years, the worst performing year in the US bond market was down less than 5%, and 2021-2022 was the only period during this timeframe that we experienced back-to-back negative return years.
Well, for the patient bondholder we anticipate things will get better very soon, which is what we’ll be examining here today.
To Explain What May Be In-Store for Bonds Next, It’s Best to First Look Back On How We Got Here…
Since March 2020, the Fed has been on an aggressive interest rate increasing cycle to slow down inflation. And while this is often bad news for the stock market (“Don’t Fight the Fed”), the impact it has had on stocks has been minimal compared to the impact on bonds. (The S&P 500 is up 27% annualized over the same three-year timeframe).
The reason is simple, but sometimes difficult to understand and visualize: Bond values move inversely to interest rates. Or in other words, higher interest rates equate to bond values falling.
Here is a good analogy to remember this key concept: A friend owes you money and you create a contract with them (or a “bond”) that says they will pay you 2% interest for 5 years, which is the going rate at that time. Three years later, the going rate is now 5% for what you could get to loan your money. However, your friend is still paying you only 2% and will be for another two years. Thus, you must wait two more years to get your money back to get the higher 5% rate. As a result, if you were to try to sell your contract with your friend to another investor, you would have to do so at a discount to offset the lower than current interest rate. However, if you simply wait until your contract is over, you will still get back the full value from your friend. You simply missed out on the higher interest rate opportunity. This is exactly how bond prices work when interest rates increase.
Now, the Fed has raised interest rates before and bond prices held up relatively okay. However, this time was different because of three key reasons: 1. The amount of the increase (going from 0 to 5%), 2. The speed of the pace (10 consecutive interest rate increases and 11 times in total), and 3. Because the Fed Funds Rate was at zero when they started.
The Fed Funds Rate being at zero when they started is especially important because when bondholders were only getting 1-2% interest on their bonds, which eventually fell 15-20% in price, there wasn’t enough interest income to offset that large of price fall. If bondholders were getting 4-5% interest, which is where we are at today, the price fall wouldn’t have felt nearly as bad.
Fast Forward to Today … The Rewards for Staying Patient in Bonds are Likely Just Around the Corner
Here are Three of the Key Reasons Why:
1. Interest rates are likely much closer to their peak than to their trough. What we’ve heard from the Fed is that while a further interest rate increase may still be on the table, it does appear they are just about done raising rates. Most polled economists, as well as the futures market, believe the Fed is in fact done. And while the Fed only sets short-term interest rates, there continue to be several deflationary factors that should keep a ceiling on how high interest rates might be able to go. What this means for bondholders is that the painful three-year price fall in bonds is getting close to being over. Soon bonds should provide protection once again.
2. Even if rates don’t fall immediately, the interest rates on bond funds should continue to increase as time goes by. Bond mutual funds hold thousands of bonds, and those purchased within the last 15 years have extremely low interest rates to them. Think about it – the majority of all investment grade bonds issued between 2010-2020 were with interest rates between 1-3%, and those are still the same bonds that the mutual funds are holding and we as shareholders are getting paid from. As these low interest rate bonds mature within the bond funds, fund managers can now reinvest those monies at much higher rates. In theory, if you have already stomached the pain of prices falling and you’re okay with waiting for their recovery, it benefits you more if interest rates stay higher for longer because more low interest rate bonds will mature, and more higher interest rate bonds can be purchased.
3. Interest rates falling back down is inevitable, resulting in bond values appreciating in price. Just as bond prices fell when interest rates went up, the prices of those same bonds will recover when interest rates finally do come back down. And if we do go into a recession in 2024, the Fed will likely start cutting rates much sooner than we expect today, sending bond values higher. After all, the economy is not designed to function in this high-rate environment forever. In the Fed’s most recent projection, they anticipate the Fed Feds Rate is back down to between 2.5% to 3% by 2026, which is half of where it sits today. Interest rates coming back down (and bond prices recovering) is not a matter of if, but a matter of when.
Most investors have been naturally trained to have patience in stocks. “Think Long-Term,” or “It Always Comes Back” are mantras we hear a lot when it comes to stock market investing. Waiting patiently for bonds to recover to provide positive returns is not nearly as natural, nor is it ingrained in our investing psyche. For the last few years, it’s been an incredibly unique and challenging time for bond prices … but soon your patience will pay off.
Disclosure: Bridge The Gap Retirement Planners LLC (BTGRP) is an Investment Advisor registered with the States of CA/AZ. All views, expressions, and opinions included in this communication are subject to change. This communication is not intended as an offer or solicitation to buy, hold or sell any financial instrument or investment advisory services. Any information provided has been obtained from sources considered reliable, but we do not guarantee the accuracy, or the completeness of, any description of securities, markets or developments mentioned. We may, from time to time, have a position in the securities mentioned and may execute transactions that may not be consistent with this communication's conclusions. Our current disclosure brochure, Form ADV Part 2, is available for your review upon request, and on our website, btgretirementplanners.com. This disclosure brochure, or a summary of material changes made, is also provided to our clients on an annual basis.