“Bondholders are going to be in for some nasty surprises…because the losses are piling up.” CNBC’s Kelly Evans
A bond is a debt security, similar to an IOU. Borrowers issue bonds to raise money from investors willing to lend them money for a certain amount of time.
When you buy a bond, you are lending to the issuer, which may be a government, municipality, or corporation. In return, the issuer promises to pay you a specified rate of interest during the life of the bond and to repay the principal, also known as face value or par value of the bond, when it “matures,” or comes due after a set period of time.
Just as individuals get a mortgage to buy a house, or a car loan to buy a vehicle, or use credit cards, corporations use debt to build factories, buy inventory, and finance acquisitions. Governments use debt to build infrastructure and to pay obligations when tax revenues fluctuate. Loans help to keep the economy running efficiently.
Whenever the size of the loan is too large for a bank to handle, companies and governments go to the bond market to finance their debt. The purpose of the bond market is to enable large amounts of money to be borrowed.
Bonds can provide a means of preserving capital and earning a predictable return for investors. Bond investments provide steady streams of income from interest payments prior to maturity.
The bond market (also known as the debt market or credit market) is a financial market where players can buy and sell bonds in the secondary market or issue fresh debt in the primary market. Like the stock market, the bond secondary market is made up of investors trading with other investors. The original company that received the money and is responsible for paying back the money, is not involved in the day-to-day trading. The market value of bonds can fluctuate daily due to changes in inflation, interest rates, and fickleness of investors.
The United States accounts for around 39% of total bond market value. According to the Securities Industry and Financial Markets Association (SIFMA), the bond market (total debt outstanding) was worth $119 trillion globally in 2021, and $46 trillion in the United States (SIFMA). The worldwide bond market is almost three times larger than the global stock market.
“I used to think that if there was reincarnation, I wanted to come back as the President or the Pope or as a 400 basball hitter. But now I would like to come back as the bond market. You can intimidate everybody.” James Carville
The bond market is more important to the health of the U.S. and global economies than the stock market. And, you prefer for the bond market is not in the news, to be boring and functioning smoothly. Disruption in the bond market is what can get the economy in trouble.
As with any investment, bonds have risks which include:
- Interest rate risk. Interest rate changes can affect a bond’s value. If bonds are sold before maturity, the bond may be worth more or less than the face value. Rising interest rates will make newly issued bonds more appealing to investors because the newer bonds will have a higher rate of interest than older ones. To sell an older bond with a lower interest rate, you might have to sell it at a discount.
- Inflation risk. Inflation is a general upward movement in prices. Inflation reduces purchasing power, which is a risk for investors receiving a fixed rate of interest.
In aggregate, bond values are down significantly over the past three months–one of the worst quarters the securities have experienced since the 1980s, explains CNBC’s Kelly Evans. According to Natalliance, “government bonds are on pace for their worst year since 1949.”
Famed former Legg-Mason investor Bill Miller warned several years ago that “when people realize they can actually lose money in bonds, they panic”. Going into the inflationary 1970s, he said, “investors had done so well in bonds for so long they viewed them as essentially riskless, until it was too late.”
Investors have been warned for years about a bond crash that never panned out until recently. The chorus of financial pundits have said that the Federal Reserve’s massive quantitative easing and the federal government’s fiscal response to the financial crisis would ultimately cause inflation and crater bonds, it turns out they were right.
As a result, investors are piling out of bonds, which have seen outflows for ten straight weeks. Municipal bonds have seen historic outflows and are about to post their worst quarter since 1994, down more than 5%, according to Bloomberg. Investors have also been fleeing high-yield debt, especially as the Fed has turned increasingly hawkish this month.
You won’t find many financial professionals, other than fixed-income specialists, recommending big exposure to bonds right now. The outlook is just too uncertain.
“Bonds have nowhere to go but down since [interest] rates have nowhere to go but up.” Liz Young, SoFi Chief Investment Officer
Bonds are not expected to rally or perform better if growth slows, unless there is a meaningful dent in the outlook for inflation, and it would take a very deep and lengthy downturn to do so, as economists and financial pundits have warned.
Bonds have sold off and they haven’t served as downside protection within an investor’s diversified portfolio of stocks and bonds. Year-to-date, bonds have returned -8.7% YTD on 7-10-year Treasury bonds compared to a -6.0% YTD return in the S&P 500.
When bonds are in the red and cash is losing value because of inflation, investors turn to the stock market, at least tactically.
In this environment, “real assets” like real estate and commodities have done extremely well tend to do well in a tough investment environment for the long run (gold, metals, energy — along with globally diversified real estate).
As for stocks, Bill Smead, of Smead Capital Management, likes energy and housing market plays; noted investor Bill Miller likes energy, financials, housing stocks, travel-related names, and even some Chinese stocks (he’s also still bullish on mega-cap tech like Amazon and Meta).
The S&P 500 overall has been impressively resilient thus far, hanging in there with drop of less than 5% since the start of January–less than bonds, in other words. As bond losses deepen, don’t be surprised to see the “TINA” (There Is No Alternative) dynamic continue to bolster stocks.
However, there are several good reasons for purchasing bonds and including them in your portfolio:
- Bonds are a generally safe investment, which is one of their advantages. Bond prices do not move nearly as much as stock prices.
- Bonds provide a consistent income stream by paying you a defined sum of interest twice a year.
- Bonds provide diversification to your portfolio, which is perhaps the most important benefit of investing in them. Stocks have outperformed bonds throughout time, but having a mix of both can lower your financial risk.
References:
- https://www.investor.gov/introduction-investing/investing-basics/investment-products/bonds-or-fixed-income-products/bonds
- https://www.themoneyfarm.org/investment/bonds/why-is-there-a-market-for-bonds/
- https://www.sofi.com/blog/liz-looks-stocks-vs-bonds/
- https://www.cnbc.com/2022/03/28/kelly-evans-its-getting-ugly-out-there-for-bonds.html
- https://archerbaycapital.com/bond-market-more-important-to-economy/
Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining market equity values.