The Great Expectations Game: Putting the Recent Bond Market Volatility in Context
Bonds and equities are two very different animals in the investment universe and yet are similar in at least one important way — both are priced based on investor expectations. For equities, the outlook is reflected in price-based valuation metrics such as the price/earnings (P/E) ratio of growth stocks. Because these companies are expected to grow earnings at a much higher rate than the average business, they trade at a higher P/E multiple. In effect, the expectation of faster growth results in higher relative prices paid by investors. Bond prices and yields also reflect expectations, however with fixed income, the relationship can seem murky, and that lack of clarity appears to be costing some investors money.
Managing to expectations
Probably the least understood aspect of fixed income is how market expectations are reflected in pricing. The shape of the curve — a graphic plot showing the yields earned on bonds with different maturities — can suggest expectations about a tightening or easing cycle by the Federal Reserve. Meanwhile corporate bond spreads can highlight the views of investors on the likelihood of potential defaults among bonds with different credit ratings. Even municipal yields versus taxable bond yields can point to the market’s outlook about future tax rate changes (among other things). Simply put, understanding expectations and the price distortions they create is key to generating excess returns over time. Conversely, overlooking or misinterpreting expectations and distortions is also how investors have done the most damage to their portfolios.
Adverse selection
According to Morningstar’s “Mind the Gap” study, during the 10-year period ending in December 2019, investors gave up more than 26 percent in returns relative to the benchmark in municipal bonds and 20 percent in taxable bonds by moving money in and out of bond mutual funds at the wrong time. Generally, this means investors sold when bond prices fell and rates moved higher; and they bought when rates moved lower as a result of rising bond prices. Much of the poor market timing can likely be chalked up to overlooking what expectations were being priced into bonds. In the current environment, we believe some of the same mistakes are being made. Investors are pulling money out of bond funds, in part, because the Fed is hiking interest rates and investors are not factoring in what current bond prices are saying about expectations for rates in the future.
Many investors seem to believe they should sell their bond holdings because the Fed is raising rates and Treasurys issued at the higher rates will reduce the value of the investor’s current fixed income holdings. That thinking strikes us as flawed for two reasons. First, different parts of the curve will be more or less sensitive to Fed actions than others; and some rates may actually decline meaning some existing Treasurys will go up in price. Second, it doesn’t matter what an investor thinks the Fed is going to do, only how their expectations differ from what is already reflected in the market. In the case of the current market backdrop, the market is pricing in eight hikes between now and mid-December 2022 and possibly another hike in February 2023. This is expected to take the federal funds rate to 2.75 percent to 3.00 percent from its current .75 percent to 1.00 percent. How much of this Fed tightening is built into fixed income prices? All of it. Fixed income math can get complicated quickly, with that in mind we’ve included the chart and table below to show what we mean by the statement “Fed hikes are built into the curve.”
Tightening is built into the curve
The chart below is a visual representation of how much Fed tightening is built in. It shows the difference between what the market expects a three-month bill to pay when issued 18 months from now and what the current rate is on a three-month bill. As you can see, most of the expected Fed rate hikes are already priced in — the two-year return reflects the amount of expected tightening during the next 24 months. This chart should be reassuring to those concerned about what will happen to bond prices if the Fed follows the script already laid out. If the Fed takes such a script, it’s likely that not much will happen — as the forecasted rates are already priced in. While the chart focuses on two-year Treasurys, the same concept applies to bonds further out on the curve. It is inaccurate to assume that just because the Fed is going to raise rates 200 basis points, longer maturity bonds will experience the same increase in the future. Yields have already increased.
To further illustrate how pricing in expected rate hikes will impact a portfolio, let's look at a hypothetical client who wants to move out of fixed income and into cash due to fear of the Fed hiking interest rates. This is a way to evaluate returns over the next two years based on potential Fed moves. For this example, we are using a three-month Treasury that is rolled over each quarter as a proxy for what an investor might expect to earn in a cash reserve account. Also, although the Fed meets more than once a quarter, we assume quarterly hikes for simplicity.
We’ve included two scenarios in the table to illustrate two potential paths the Fed could follow. One mirrors expectations of the current Fed tightening cycle and the other is an alternative scenario in which the Fed pauses or significantly lengthens the expected tightening period due to market volatility or a stagnating economy.
In the very aggressive Fed tightening cycle (scenario 1) that priced into the current market, you can see that a strategy of continually rolling over short-term Treasurys yields the same as a strategy of simply buying the two-year Treasury and holding it to maturity. This makes perfect sense, since as we have seen in earlier graphs, this amount of Fed tightening is already priced into the yield curve.
Now let’s look at a scenario in which the Fed isn’t as aggressive (scenario 2). As you can see, the hypothetical investor would be missing out on potential upside by holding cash instead of buying and holding a two-year note.
Although the example above focuses on the two-year Treasury, please note that the Fed expectations built into the two-year note are also built in across the curve.
Hopefully, the charts and examples in this article have provided you a better understanding of the importance of knowing what expectations are already priced into bonds before making changes to your fixed income asset allocation. A very oversimplified way to think about all this is to think about every Fed hike as worth $25. You have two options: lock in returns by buying a bond that has a term at least as long as the Fed hiking cycle is expected to last, or sit in cash and get returns based on what the Fed actually does. If the Fed hikes as expected, you’ll get $200 (eight 25 basis point hikes) either way. Obviously, if you believe the Fed is going to tighten more (or faster) than expected, sitting in cash may be the preferable option. But remember, eight hikes are the baseline, which is extremely aggressive based on past hiking cycles. On the other hand, if the Fed hikes fewer than eight times at 25 basis points each, then buying the bond is likely the preferred route. While no one knows for sure what the Fed will do, we believe it may take a more dovish tone than is widely expected.
As always, If you’re concerned about how recent volatility in the bond market could impact your financial plan, you should have a conversation with your advisor. However, it’s important to remember that high-quality fixed income is an important source of diversification in a comprehensive financial plan and can protect investors during a recession. While the recent pullback was unusual, a comprehensive financial plan is constructed to account for the unexpected. In the coming weeks, we’ll provide a further look at the ways investors can turn the current volatility into long-term opportunity.
