Value in high-quality bonds

This has been a devastating year for fixed-income investors but much of the damage should now be behind us


This year has been the worst year for bonds since the Great Depression of the 1930s.

The Bloomberg Aggregate Bond Index, the most widely used benchmark for the broad, diversified investment-grade US bond market, has returned a negative 16.0 per cent so far this year through last Friday. This compares to losses of 21.4 per cent for the S&P 500 Index. Even very short-term bonds, which have historically been very stable, are down this year.

It is not normal for high quality fixed income investments to have negative total returns over a 12-month period. For example, based on data provided by Bloomberg, since 1976, there have only been 65 instances out of a total 550 where the broad fixed income index was down over a 12-month period. That’s just shy of 12 per cent of all instances.  

It is even rarer for both bonds and shares to be down at the same time over a 12-month rolling period. Historically, bonds have provided a buffer when equities fell. Since 1976, there have only been thirteen 12-month periods, or 2.4 per cent of the time, where both bonds and equities were negative.

Bond investors globally are experiencing large paper losses this year for two primary reasons. To start with, yields were initially very low and the pace of rate hikes by monetary authorities globally has been very rapid. For example, since last March, the Federal Reserve in the US has increased the federal funds target rate six times, pushing it up from near zero to a range of 3.75% to 4.00% only last week.  

This has been the fastest and most aggressive pace of tightening going back to the early 1980s. Because bond prices and interest rates (or yields) move in opposite directions, the steep rise in rates has automatically led to deep drops in bonds prices. However, going forward, the pace of rate hikes should slow down as hinted by the Fed last week, and ultimately stop, which should limit the upside for longer-term bond yields.

Now that yields have re-set at much higher levels, the blow from price declines should be cushioned by higher coupon income. Bond returns mostly comprise a coupon return and changes in prices. Coupon returns are always positive and have historically provided a buffer from falling prices. Because yields were so low at the start of the year and rose very sharply, the coupon return was not large enough to offset the decline in prices, resulting in nearly the worst 12-month total return for the bond market since the 12 months ending in 1977.

Obviously, all sections of the bond market have experienced losses this year, with some being much more impacted than others. Long-dated bonds, for example, are more sensitive to interest rate changes and that is why the losses here are more pronounced. Moreover, the performance of high-yield bonds also very much correlates to that of the economy, in that a weaker economy raises the risk of default, which is already running above the worst levels for the past five years.

At this stage, it is likely that the worst of the impact on the bond market should be behind us.

Interest rates have already risen so rapidly that the average yield for the kind of high-quality bonds in the Bloomberg Aggregate index is already running above 5 per cent. That is already an attractive income stream for long-term investors. Moreover, it may be opportune for investors to start considering extending duration to take advantage of the move up in yields and stay up in credit quality by focusing mostly on higher-rated bonds.

Disclaimer: This article is brought to you by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd, which is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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