The first quarter of 2022 saw both stock and bond markets fall, which is an unusual event that we thought warranted more discussion. Generally speaking, bonds have experienced a 40-year bull market – and there’s rarely been bad news to tell our clients – but in Q1, bonds experienced their third worst quarter performance-wise in the past 50 years1. Given this background, we sat down with Mark Murphy, RIA’s Chief Investment Officer, to have him answer some of the burning questions we’re hearing from clients today.
Why are bonds performing so poorly?
In short, it’s a result of inflation remaining higher for longer than many expected and the Federal Reserve’s comments about the actions they are planning on taking as a result.
The Federal Reserve (Fed) has two primary goals: 1) to maximize employment and 2) control inflation. Employment has improved significantly since the depth of the Covid induced recession and is beyond the Fed’s full employment target, meaning their first goal is being met. The Fed had expected inflation to ease last year as supply constraints from the pandemic eased, however that hasn’t been the case and inflation has accelerated. The March CPI reading of 8.5% inflation over the last twelve months was its highest level in over 40 years. The Russian invasion of Ukraine has exacerbated supply chain problems and put additional pressure on commodity prices. The Fed is now focused on slowing inflation. To do so they need to slow the economy by pulling back on their easy money policies. This includes using their main tool, raising the fed funds rate (the interest rate at which banks and other institutions lend money to each other), as well as reducing the number of bonds they hold on their balance sheet. Late last year expectations were for a few incremental fed fund increases in 2022. However, the Fed has progressively made more hawkish comments about getting inflation under control and making aggressive moves to do so. After raising the fed funds rate 0.25% at their March meeting, Fed Chair Powell recently said 0.5% rate increase (which hasn’t happened in 20 years) will likely be made at their next meeting. In addition, many Fed Governors have advocated for multiple 0.5% rate increase this year. Markets have been factoring in these comments into their expectations for interest rates and we have seen interest rates rise significantly since the beginning of 2022. When interest rates rise, bond prices fall due to new bonds being available at higher yields. As a result, the bond market has been down to start 2022.
Aren’t stocks and bonds supposed to have a low level of correlation?
Correlation means how similarly one investment moves in relation to another investment. Low correlated assets increase diversification in a portfolio and provide protection from portfolio declines. Typically, we see stocks and bonds behave differently in times of market turmoil. If stocks are doing well because of strong expected economic growth, bonds might lag as interest rates often rise in those times. If stocks have a significant pull back, investors typically flock to safe havens like high quality bonds. High quality bonds have shown to be a great hedge against stocks, particularly when stocks are at their worst. They performed very well at the onset of the pandemic, during the financial crisis and during the Dotcom bubble. We have seen this relationship still hold up recently with high quality bonds up from 4/20 – 4/26 when stocks pulled back over 6% and earlier this year high quality bonds performed well when Russia first invaded Ukraine. However, the Fed suggesting they will raise interest rates so substantially and quickly have forced investors to reprice their valuations of stocks and bonds, driving both assets down. While unique, both asset classes behaving similarly is certainly possible over a short time period. However, over the long term we still believe the low correlation that we have seen historically will continue to hold.
Why should I continue to own bonds?
While seeing declines from your bond allocation is disappointing, it’s a positive long term and is a self-correcting problem. The bonds held in your portfolio that mature can be reinvested at the current higher rates, so as interest rates rise, the expected return from your bond allocation increases as well. It just takes some time for the yield of your bond portfolio to catch up. You will eventually see your bonds return to positive performance, whereas with equity there is no guarantee that will occur and there can be long stretches when it produces flat or negative performance. For example, the S&P 500 had an annualized return of -1.0% over the 10 year period from 2000 to 2009. Another benefit from an increase in interest rates is higher rates enable high quality bonds to provide greater protection to a stock market pullback. Frequently, investors flock to safe havens when stocks have significant declines. This pushes bond values up and yields down. With interest rates close to 1% over the past two years there was more limited ability for rates to decline and for bond allocation to provide a hedge against a stock market pull back. Now with rates closer to 2.5% bonds have the potential to provide a greater cushion. In addition, while bonds can decline, their potential declines pale in comparison to the declines that can occur on the equity side of the portfolio. They still offer stability for a portfolio because their day to day fluctuations are much more measured compared to how much stocks can fluctuate.
Why not sell our bonds and move to cash?
By selling your bonds and moving to cash it would protect your portfolio if we see rates rise more than expected. Currently investors are anticipating the Fed will raise the fed funds rate another 2%+ over the next year so multiple interest rate increases are already factored into bond prices. Comments and actions taken by the Fed would need to be more aggressive for the fixed income to fall substantially from its current levels. By moving to cash you are ensuring those funds will not keep up with inflation. Bonds provide a yield whereas cash does not. That yield in time will move more closely in line with inflation. Moving to cash is essentially an attempt to time interest rates and we don’t believe that is a reliable way to invest long term. If cash is needed in the near future than selling bonds and holding the funds in cash would be reasonable, but if there is no immediate need I recommend remaining invested in fixed income and benefiting from the higher yields the bonds are now providing.
What investments best combat inflation?
We believe that stocks are the best long term hedge against inflation. Value stocks, or lower priced stocks, often perform well in inflationary environments because their revenue is typically more near term compared to growth stocks whose revenue is based on more distant expected earnings. As a result, inflation does not reduce value stocks’ earnings and therefore those companies’ valuations as much. We recommend maintaining a value emphasis in stock allocations unless other preferences take precedence. Real estate also often performs well in inflationary environments and we recommend maintaining exposure there as well. On the bond side of the portfolio we recommend keeping the portfolio shorter term than the broad bond market. Shorter term bonds mature sooner and can be reinvested in current market rates faster and can therefore reinvest in higher yielding bonds more quickly.
Other options include Treasury Inflation Protected Securities, or TIPS, which adjust their coupon payments based on the change in inflation. They provide a hedge against unexpected inflation, so if inflation is higher than investors expect your investment would be protected from that. However, if inflation is in line or less than expected it would perform worse than a comparable Treasury bond. Commodities also can perform well in inflationary times and the commodities market has performed very well so far in 2022. However, they can experience significant stretches of underperformance. We believe over the long term that while they have a similar level of volatility as stocks, they will likely trail stocks performance.
What changes are you considering or implementing in client accounts due to current conditions?
Currently, we are actively looking at shortening the average maturity of the bond allocation in client portfolios. While we typically recommend keeping the bond allocation shorter term than the broad bond market, given the significant volatility from bonds over the first third of the year we are considering moving them even shorter term to provide increased stability. Capital preservation and stability are the primary goals we seek from bonds and moving the bond allocation even shorter term can help provide that in the current environment.
1 Vanguard calculations using data from Morningstar, Inc., as of March 31, 2022.