6400 S Fiddlers Green Cir,
For most of the past decade-and-a-half, interest rates have been very low. Bond investors have been forced to move into riskier investments. It was called T.I.N.A., or There is No Alternative. Fixed income, bonds, etc., were not providing any income. Investors moved into other assets that were typically more volatile like dividend-paying stocks, MLPs, or REITs.
Given the rise in interest rates over the past two years, investors can once again earn something in fixed income. There is no longer a need to chase yield.
However, there is a reason why we can get yield once again. Bonds have been beaten down as interest rates have risen. Think of bonds as being on a see-saw. As interest rates rise, bond prices fall and vice-versa. This makes intuitive sense because if you own a bond that pays you 3%, and a new bond is issued that is the same in every respect but pays 4%, the 3% bond will fall in price until they both pay 4%, creating an efficient market.
The paradox is that the more bonds get beaten down, the better the protection they provide and returns they produce.
Bonds are fundamentally different than other financial instruments. Bonds are financial obligations (think “loans”) that are contractually obligated to pay periodic coupons and return principal at or near par at the maturity of the bond.
The maturity value is known, so barring a default, there is a known appreciation value at the time of purchase. While the price of the bond will fluctuate based on market conditions, it will gravitate towards par over time.
That is, there is a certainty with bonds that you don’t get from other risk assets. Bond math is fairly easy as the starting yield, or the yield on the bond when you purchase it, is going to be very close to your total return over the life of the bond.
Back to the paradox, as the price of a bond declines, the starting yield goes up. That doesn’t mean if you own that bond your total return is going to be higher, but it does mean that the return from that point will be higher. In other words, as bond prices fall, the better potential return there is in them going forward.
While many investors and clients have an unrealized loss in their accounts because of the rise in rates, it is temporary.
Given the rapid rise in interest rates, deeply discounted bonds are not prevalent in the markets. This is a once-in-a-lifetime opportunity to achieve 6%+ yields with low risk. High-quality bonds have about 15% of the volatility of the S&P 500, according to yCharts.
We believe this anomaly in the market won’t last forever. Once inflation subsides, the Fed will pivot and not only stop raising rates but lower them. This is called the ‘Fed Pivot.’
The only reason rates are this high is because of inflation- and inflation is only high because of Covid and the policy response to it. The amount of money printing and spending was prolific. Nearly $7T of stimulus was manufactured. That’s about three-times what they did during the Financial Crisis.
Inflation is moderating but remains high. The Fed continues to raise rates (orange line is proxy) and is approaching the Core CPI Inflation (blue line) headline inflation (purple line). Historically speaking, once rates get above inflation (positive real rates), inflation tends to fall sharply.
Additionally, often when real rates are positive for a sustained period of time, a recession ensues.
This would then cause the Fed to pivot as the natural neutral rate for the Fed Funds rate is 2.5%.
What happens then?
Go back to our see-saw image. Rates would fall and your bond prices would rise in value.
Bonds had a terrible year in 2022. Interest rates are still going up which means more pain may be in store for them. However, we would advocate for a long-term perspective. Rates are up and as we shift to individual bonds in portfolios (as they become ownable again after 15 years), we are locking in yields-to-maturity of 6%+.[ii]
Over time, any discounts on bond prices (due to rates rising) will reverse as the bond approaches maturity. In other words, principle that was lost will return (so long as the bond doesn’t default). We are buying high-quality bonds (no junk) that have a very low probability of going bankrupt.
That is the kind of certainty and lower risk that we like. We can achieve a 6%+ yield in very high-quality bonds instead of rolling the dice in the stock market and attempting to achieve maybe 2% more per year.
Remember what we said about the differences in risk earlier. Investment grade bonds exhibit about 15% of the volatility (“risk”) that the S&P 500 does[iii]. So, you’re taking multiple times the risk in order to maybe get 2% extra while riding a roller-coaster in prices when moving into stocks.
This, like anything, won’t last. Eventually rates will fall and the differential in bond returns versus stock returns will normalize closer to 4-5% where it has been historically. But for now, we think this is one of those generational opportunities that requires patience and a long-term perspective.
As always, we appreciate your business and the trust you place in us.
Mark J Asaro, CFA
Noble Wealth Management