The first quarter of 2022 was shocking by fixed income standards with the Bloomberg Barclays Aggregate Index declining 5.93 percent during the period. Unlike more risky assets like stocks or high-yield bonds, a quarterly loss of more than 5 percent in the high-quality fixed income space is very rare. The chart below shows the severity of the recent decline in bonds. In total, the Bloomberg Barclays Aggregate Index, was down a whopping 7.72 percent since the high in August 2020 (and actually reached a maximum drawdown of 8.66 percent).
While the immediate sting felt by bond investors is real, it is important to view it in the broader context of a diversified portfolio. Compared to volatile asset classes such as stocks, the drawdown is an unpleasant blip rather than a seismic jolt. For example, since 1999, the S&P 500 has had two drawdowns of greater than 50 percent and several more of 20-plus percent. So, while investors may feel burned by the recent move in fixed income, it is more like a sunburn compared to the scalding stocks have occasionally delivered during the past two decades.
Differences in drawdowns
Beyond the size of the drawdowns, there are a few other differences to highlight when looking at high-quality fixed income versus equities. A correction in fixed income is significantly shallower and tends to be over much sooner than an equity correction. Also noteworthy is the way equity drawdowns have evolved during the past 10 years as “buy the dip” has become common practice for many equity investors.
Here’s my take on buying the dip: if buying the dip in equities has become a meme, buying the dip in fixed income is math. What do I mean by that? A correction in equities can be sparked by earnings impairment, as well as other factors. In simple terms, the decline may be warranted because prospects for future earnings growth may have weakened and are unlikely to improve quickly enough to justify previous valuations. In the high-quality fixed income space, impairment or default is extremely rare. This means that with every dip in price, a high-quality bond’s internal rate of return increases. A simple example can help clarify this. Assume you purchase a 5-year Treasury bond with a 2 percent coupon that matures on April 1, 2027 at $100 (par). Now let’s say rates rise the next day by 100 basis points to 3 percent. Your bond is now less attractive to buyers and the price declines to $95.398. Yet we know the bond will still be redeemable at par ($100) on its maturity date. How does it close the gap? It compounds at a 3 percent rate going forward. Keep in mind that unlike stocks, bonds have contractual maturity dates. As a result, if they are high-quality and mature at par, there is a natural progression back to the issued value of the bond. Again, math, not meme.
Be a goldfish
This was the third worst quarterly return for the Bloomberg Barclays Aggregate Index going back to 1976, but it provides an opportunity to identify whether a fixed income allocation or portfolio performed as expected. If your bond portfolio had a longer duration than the benchmark and it underperformed, that is to be expected. However, if the portfolio was underweight duration and underperformed you should investigate further. A portfolio that performs in unexpected ways may be out of alignment on a duration, curve, credit, volatility or liquidity basis. Any unintended underweight/overweight can now be discovered and remedied. However, overly focusing on a bad quarter is counterproductive to allocating risk and positioning a portfolio for the future. One bad quarter should not lead to wholesale changes to a well thought out financial plan.
For those who are a fans of the tv series Ted Lasso, you’ll know the phrase, “be a goldfish,” which roughly means forget about those things you can’t control and move forward (a goldfish has a short memory, so it moves past things quickly). This quarter has been difficult, so acknowledge it, put it in perspective and move forward. The case for high-quality bonds in a diversified portfolio remains valid. They still are far less volatile than equities and provide diversification from credit risk (high yield, private credit and equities). Also, they are one of the few assets that provide protection in a recessionary environment. Allocating to fixed income within a financial plan that takes into account a client’s goals and risk tolerance should not be significantly impacted by a quarterly decline that happens less than 2 percent of the time.
Finally, remember that forecasting interest rates is a game of chance. Whether rates are higher or lower in any given year is a 50/50 proposition. Keep in mind, at the December 2018 meeting the Federal Open Markets Committee predicted the Federal Funds rate would be 3.125 percent at the beginning of 2021. Two years later, the upper bound was .25 percent and the effective rate was .09 percent (effectively zero). If the Fed can't predict an interest rate they actually control, how can anyone be expected to predict 10-year Treasury yields or any other benchmark yield in the fixed income space? We point this out because many may be worrying about what they should do given the Fed is expected to raise rates by an additional 2.25% in the coming months. The good news is that not much needs to be done — the rate hikes are already reflected in bond prices. Remember, the 2-year U.S. Treasury has gone form yielding 0.25% in September of 2021 to 2.75% today, meaning rise in yield reflects the expected tightening.
Many fixed income topics are very math intensive and can be challenging, which makes volatility such as this even more unnerving. The chart above may be able to provide some comfort. This chart represents a theoretical 5-year constant maturity Treasury bond. The bond never matures, it remains a 5-year bond through the entire period from 1926-2021. This reflects the best approximation of how bond mutual funds and separately managed portfolios are constructed. The chart shows that intermediate bonds have provided investors who have a reasonable investment horizon a positive return on a five-year rolling basis through many uncertain and volatile circumstances. Even through the inflationary spike of the 1970s intermediate bonds have provided a positive return for those with a five-year horizon.
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.