Market volatility brings bonds back in vogue!
S&P 500 has gained/lost more than 1%, 22 times in Q1’18
Bonds outperformed Stocks despite rising rates in February and March ‘18
Investors looking to dump their fixed-income investments as rates rise may want to take a step back to avoid missing the forest for the trees.
Markets went from not caring about any wall of worry in 2017 to caring about any and every news piece in Q1’2018. Over the course of the past 3 months, the S&P 500 experienced 6 trading days of +/-2% moves, compared to 2017 when we saw zero such moves, which resulted in a bumpier ride for investors. After starting the year off with a bang in January, U.S. large-cap equities were down 0.8% through the end of March as investors absorbed the implications of trade tensions, higher interest rates, firming inflation and fiscal stimulus.
This market volatility brought back attention to bonds. A breakdown of monthly returns shows bonds held up much better than equities in past 2 months despite rates moving up.
|January 2018||February 2018||March 2018|
|S&P 500 Index||5.62||-3.89||-2.64|
|Bloomberg Barclays US Agg Bond Index||-1.15||-0.95||0.64|
Fears that rising interest rates would end the multi-decade bull market in bonds have taken over the market. Some investors aren’t that comfortable with bonds, either because they don’t have much experience with them or have been trained to think that interest rates must rise (because they’re low) and that that means doom for bonds.
It’s important to remember that the short-term challenge of an interest-rate increase generally doesn’t supersede the long-term reasons for holding bonds in your portfolio. If you are an investor with a long-term horizon and believe in all-weather portfolio, here are 5 tips on overcoming your fear of bonds:
1) Stock Market Volatility does not equal Bond Market Volatility: When an investor thinks about a down market in bonds, they usually picture a down market in stocks. A year’s volatility of the bond market might feel like a month’s volatility in the stock market. Bonds serve as a potential counterbalance to equity market volatility. In the U.S., the biggest one-year decline for 30-year corporate bonds (going back to 1857) was 12.5% for the 12 months ending February 1980. By contrast, the biggest one-year decline in the stock market, the S&P 500 lost 67.8% in the 12 months ending May 1932. The S&P 500’s one-year losses have exceeded the bond market’s biggest single loss (12.5%) 23 times since 1900. Source: Robert Shiller, Project Syndicate.
Another way to compare stock and bond market volatility is to look at the number of down years in the bond market when stocks were down and vice versa. The charts below show how bonds act to stabilize portfolio returns over the last 91 years. The top chart shows bond returns being positive in 24 years (100% time) when the stock market was down (24 out of 91 years or 26% of the time). The bottom chart shows stocks and bonds being negative only twice (17% time) when the bond market was down (12 out of 91 years or 13% of the time).
Source: Morningstar EnCorr and Fidelity Asset Allocation Research Team (AART), as of 12/31/17. Investment-grade bond returns are represented by the BBgBarc U.S. Aggregate Bond Index from January 1976 and by a composite of the IA SBBI U.S. Intermediate-Term Government Bond Index (67%) and the IA SBBI U.S. Long-Term Corporate Bond Index (33%) from January 1926 through December 1975. Stock returns are represented by the performance of the S&P 500 Index. Past performance is no guarantee of future results. It is not possible to invest directly in an index. All market indices are unmanaged.
So abandoning bonds in a rate rising environment might result in a bigger mistake than the negative price return of the bond itself. Bond downturns tend to be modest and short-lived and unlike stock downturns. Looking forward, if you expect a bumpier ride relative to last year, an effective way to soften those bumps is through a well-diversified portfolio consisting of stocks and bonds.
2) Rising Rates are good for bonds:
A controversial statement indeed when we know that bond math shows bond prices decreasing when rates rise. We are trained to think that interest rates and bond prices are inversely correlated, but the reality is that rising interest rates cause bond prices to fall in the short-term, but do not impact the long-term coupon payments that bond is structured to pay. When interest rates rise, investors can reinvest their principal and coupon to receive a higher income, as the reinvestment rate is higher as rates rise. Eventually the higher income cushions the negative price return of the bond resulting in a positive total return from bonds.
The chart below looks at the last 4 rate rising cycles since 1994 to show municipal bonds deliver a positive return over the hiking cycles.
Annual Average Monthly return (January 1994- December 2017)Source: Morningstar, Federal Reserve, 1/18. Based on the returns for the Bloomberg Barclays Municipal Bond Index.
Interest rate-hiking cycles were measured by Fed tightening cycles. The four tightening cycles since 1994 were: February 1994-March 1995, June 1999-May 2000, June 2004-July 2006, December 2015 to December 2017.
The chart also shows bonds delivering positive returns regardless of the rate cycle, making them a vital component of a diversified portfolio.
3) Market timing does not work: In 2016, the average fixed income mutual fund investor underperformed the Bloomberg Barclays Aggregate Bond Index by a margin of -1.42%. The broader bond market realized a return of 2.65% while the average fixed income fund investor earned 1.23%.
Investors believe they can accurately time entry and exit out of bond markets and they can accurately predict rate rising and the performance of bond markets- that means they must be correct (CONSISTENTLY) 4 times! Here is a visual of the lag between expectations and reality. The average fixed-income fund investor has greatly underperformed the Bloomberg Barclays Aggregate Bond Index. Why? Investor Behavior makes them overconfident in their ability to market time accurately and the net result is poor investment decision making.
Source: Seeking Alpha, Dalbar Study, “Why Investors Suck and Tips for Advisors,” September 26, 2017, Lance Roberts of Street Talk Live. Returns showed as of December 31, 2016
Since market timing does not work, timing entry or exit from bonds could also result in a big mistake and staying invested instead would produce better results. With attractive risk-adjusted return opportunities harder to find, investors need to have patience and discipline with a defined process to avoid market timing in bonds.
4) Rate Movements are Difficult to Predict: One of the key reasons, investors flee bonds is their belief that they know the future path of interest rates. They are confident in their ability to accurately predict number and magnitude of rate rises. The chart below shows that even the professional forecasters get it wrong. The chart shows the rolling 5 Quarter median forecasts of 10-year note yields from 2001-2017, versus the actual trend in 10-year note yields. The dotted lines each year are significantly different from the black line showing the actual yields.
Source: Federal Reserve Bank of Philadelphia Quarterly Survey of Professional Forecasters, Federal Reserve Bank of St. Louis Economic Data (FRED), and FMR Co., as of 9/30/17. The black line represents the actual rolling 10-year note yield while the colored lines represent forecasted numbers. Each colored line represents rolling 5-quarter forecasts by the professional forecasters (median). Fidelity.
If the professionals cannot succeed, it would be imprudent for us to believe we can accurately predict rate movement and thereby time investment in bonds.
5) All Bonds are not the same: The bond market is much larger than the stock market and is made up of many varieties of bonds. Each of these bonds, react differently to interest rates, economic environment, and market trends. Some bonds such as floating rate and high yield bonds might generate a positive total return in a rising rate environment, and skilled active bond managers can diversify the bond portfolio to defend against threats to permanent loss of capital while generating income. The chart shows the impact of 1% rise in interest rates on multiple parts of the bond market. Bond total returns vary from -14% to +3.5%.
Source: Barclays, Bloomberg, FactSet, Standard & Poor’s, U.S. Treasury, J.P. Morgan Asset Management. Sectors shown above are provided by Bloomberg and are represented by –Broad Market: U.S. Aggregate; MBS: U.S. Aggregate Securitized -MBS; Corporate: U.S. Corporates; Municipals: Muni Bond 10-year; High Yield: Corporate High Yield; TIPS: Treasury Inflation Protection Securities (TIPS); Floating Rate: FRN (BBB); Convertibles: U.S. Convertibles Composite. Yield and return information based on bellwethers for Treasury securities. Sector yields reflect yield to worst. Convertibles yield is based on US portion of Bloomberg Barclays Global Convertibles. Correlations are based on 10-years of monthly returns for all sectors. Change in bond price is calculated using both duration and convexity according to the following formula: New Price = (Price + (Price * Duration * Change in Interest Rates))+(0.5 * Price * Convexity * (Change in Interest Rates)^2). is for illustrative purposes only. Past performance is not indicative of future results. JP Morgan, Guide to the Markets –U.S. Data are as of March 31, 2018.
If investors have bought long-term bonds in the last few years chasing yield, they should understand the implications of rising rates on long-term bonds which lengthens a portfolio’s duration, or its price sensitivity to changes in rates. One should have realistic return expectations from bonds given the low rate environment and be aware of the bonds they own. Be cautious, be aware and be wise!
The bond market is complex, and you can help your client choose among the wide range of options appropriate for them in the current market environment, based on their risk level and investment goals. As you navigate the current market volatility, and a period of expected interest rate increases, keep the following in mind:
- Staying the course in bonds has resulted in lower bond prices in the short term as rates rise, and higher total returns over the course of the rate rising cycle.
- Regardless of the rate cycle, bonds are a core consideration for a diversified portfolio given their lower correlation to equities and volatility reducer in market swings.
- Bond declines, and stocks decline are not the same.
- Market timing and rate predictions have not been successful investment strategies.
- Bank Loans, high yields, and other diverse bond sectors might be worthy of further due diligence in this environment. Consider diversifying the bond portfolios for your clients and baby boomers that are income seeking while avoiding the yield chase.
With attractive risk-adjusted return opportunities harder to find, investors need to have patience and discipline with a defined process to avoid taking on excessive risk in bonds and stocks. Stocks and bonds are both risk assets with positive expected returns. Giving up on any one of them might result in a big mistake for your clients.
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