The 40-year bond bull market ended in 2022, taking away the protection investors enjoyed by using high bond allocations in their portfolios.
Since the beginning of the year (YTD), the iShares 7-10 Year Treasury Bond ETF (NASDAQ: IEF) is down more than -10%, with the iShares 20+ Year Treasury Bonds (NASDAQ: TLT) pulling even higher with a -20% loss. On the other hand, the SPDR S&P 500 ETF Trust (NYSEARCA: SPY) fell just over -13%.
Traditionally, a diversified portfolio was thought to consist of two main components: stocks and bonds. For equities, a global allocation of broad equity indices covering all capitalizations and all sectors was considered sufficient. For bonds, an allocation to higher quality corporate debt and US Treasuries was deemed appropriate.
Investors used the bond allocation to reduce volatility and portfolio declines. In the event of a stock market crash, bonds can hold their value or even soar, allowing investors to rebalance into clubbed equity positions. But what do investors do with their portfolios when bonds fall in unison?
Why are bonds falling in 2022?
To understand why bonds have suffered so much, investors need to understand the economic drivers of their behavior. An important factor is the evolution of interest rates, as defined by the federal funds rate (FFR). This is the interest rate set by the Federal Reserve (the “Fed”) at which banks can instruct each other to borrow or lend excess reserves overnight.
The Fed recently lifted the FFR with a series of 50 basis point (0.50%) hikes to rein in inflation, which hit an 8.3% YoY increase in April alone . Additionally, the Fed has begun quantitative tightening, a process by which it sells government debt on its balance sheet. This is a direct reversal of its earlier quantitative easing policies designed to stimulate the economy during the COVID-19 downturn.
The results? Bond yields soared. Year-to-date, the benchmark 10-year Treasury yield has jumped more than 74%, briefly hitting a 52-week high of 3.167%. The May 31 post-Memorial Day trading session saw a 3.68% rise in the 10-year yield alone, sending bond prices plummeting that day.
Bond prices are inversely related to yields and, by extension, to changes in interest rates. A concept called modified duration governs this. It is defined as the change in the price of a bond given a 1% change in interest rates (up or down). The longer the duration, the more sensitive the price of a bond is to changes in interest rates. For example, a 10-year bond would lose about 10% in value if interest rates increased by 1%.
Consequently, 2022 has been a confluence of the worst possible conditions for bonds: higher than expected inflation, a series of aggressive rate hikes that are not fully priced in by the market, and soaring Treasury yields. Investors holding a 60/40 balanced portfolio have drawn almost as much as those holding 100% equities.
Why do bonds no longer work?
Bonds (especially US Treasuries) have traditionally worked well as a complement to stocks in a portfolio to hedge against equity risk due to the following factors:
- They produced an overall positive expected return if held to maturity due to the coupon interest paid.
- US Treasuries are considered risk-free in terms of default, making them a safe asset to which investors can take refuge in the event of turbulence (the flight to quality).
- Treasuries historically had a low to negative correlation to equities and decent volatility, which, in line with modern portfolio theory, made them a good asset for diversification.
- When a stock market crash occurs, the Fed often stimulates the economy by lowering interest rates, causing bond yields to fall and bond prices to rise sharply.
Point #3 is important. The negative correlation of Treasuries was prevalent during the decline in interest rates of the previous decade, but tends to fade during periods of rising interest rates or high inflation. It happened in the 1970s, 2018 and now again in 2022.
As a result, investors in a traditional 60/40 portfolio who relied on their Treasury allocations to protect themselves were unable to realize this benefit. Bonds fell along with stocks, leaving investors with nothing to keep their portfolios in the green or rebalance in equities.
What can investors do to protect their portfolios?
For young investors, staying the course and doing nothing is always an option. Interest rates can normalize over time. Investors with a long-term horizon can stick to their asset allocation plan and weather the current volatility. This approach requires strong discipline and a high tolerance for risk.
Other investors may consider high volatility assets with lower or negative correlation to stocks and bonds. Traditionally, this meant a large basket of commodities, such as oil, wheat, soybeans, gold, silver and copper. The disadvantages of this approach are high fees, high volatility, carryover from futures-based instruments, and the lack of a positive expected return over time.
An allocation to short-term treasury bills that have lower tenors may also work. The prices of these bonds are expected to lose less as interest rates rise. However, the yield is also lower, and if rates fell, prices would rise less, making short-term Treasuries less effective as a hedge during a stock market crash.
Investors may also consider holding cash in the form of ultra-short duration money market instruments. These include Certificates of Deposit (CDs) and zero to three month Treasury Bills (T-Bills). These assets have extremely short durations, effectively immunizing them against interest rate risk. However, the return on these assets is low and inflation can quickly erode their purchasing power.
Finally, investors can consider actively hedging the equity allocation of their portfolios with derivatives such as VIX futures and put options on broad equity indices. This approach is very technical and requires advanced knowledge. Risks include high costs, degradation over time and unexpected volatility. Implementing this strategy also requires a bit of market timing, which is ill-advised for most investors.
The Last Word on Bonds and Portfolio Management
The current macroeconomic environment could be unfavorable for bonds, but this will not always be the case, especially if interest rates fall in the future. For most investors, an allocation to high-quality, investment-grade bonds, in line with their investment objectives and risk tolerance, is still a good idea. Duration should be matched to the time horizon to mitigate interest rate risk. For those looking to further diversify their portfolio protection, a tactical allocation to commodities or money market instruments to reduce interest rate risk and volatility could be a sound strategy.