Bonds, which were supposed to be a safe asset class suitable for risk-averse investors and retirees, have proven in the first half of 2022 just how wrong this assumption is. The S&P U.S. Aggregate Bond Index, which measures the broad performance of publicly traded US dollar denominated investment-grade debt, is down 10% as of 24 June, the most since its inception.
The rout in bond prices was sparked by declines in high-yield Asian bond funds in 2021, which were initially affected by the default risk of real estate companies in China, like China Evergrande. It soon spread to sovereign bonds in the emerging markets. This year, even the investment grade bond funds have declined significantly in value when expected to hold their value given the stock market volatility.
This might be concerning to investors who are either heavily skewed towards bond investments or are invested in a diversified portfolio.
Major Bond Indices Are Down As The US 10-Year Treasury Yields Heads Up
The S&P U.S. Aggregate Bond Index, which measures the broad performance of publicly traded US dollar denominated investment-grade debt, has declined by 10% from the start of the year to 24 June 22.
The ABF Singapore Bond Index fund, which corresponds closely to the total return of the iBoxx ABF Singapore Bond Index, currently tracks the returns of bonds denominated in Singapore dollars issued by the government of Singapore and quasi-Singapore government entities. This ETF is down by 8% from the start of the year to 24 June 2022 despite its high grade bond holdings.
The 10-Year Treasury yield is the yield that the U.S. government pays investors to purchase its securities. This represents the risk-free rate for investors when deciding to invest in stocks and other riskier securities. The treasury yield has gone from 1.63% at the start of the year to a high of an 11-year high of above 3% by 24 June. Moreover, the 40-year downtrend could soon reverse with interest rate trending higher.
What Causes Bond Prices To Fall?
Bonds are debt instruments that are issued by companies and governments as a means of raising capital from the primary market. These bonds, which have varying maturity periods and coupon rates, can also be traded on the secondary market. This allows the investor to realize the investment in the bond before its maturity.
Usually, bonds on the secondary market are less volatile compared to share prices. This makes them ideal for investors seeking capital preservation and a steady cash flow. However, that is not to say these bonds would not also decline or appreciate in value like shares.
The volatility in bond prices can normally be attributed to the three following reasons.
Reason 1: Credit Worthiness of the Borrower
Bond prices could fluctuate based on a sudden change in the credit worthiness of a borrower.
When a borrower faces a going concern and is unable to pay the principal amount or misses a coupon payment, it would be considered a default. In such a scenario, the current lenders would be willing to take a haircut on their bonds in order to realise their investment. Similarly, new bond investors would also be less inclined to pay the par value and would demand a lower price based on the default risk. Both scenarios would result in lower bond prices.
On the flipside, assuming a stable interest environment, investors might even be willing to pay more than the par value of bonds issued by high-quality or financially strong issuers, like the Singapore government or quasi-government companies like Temasek. The higher premium is a reflection of the lower risk of default by these bond issuers compared to their coupon rate.
Reason 2: A Change In Interest Rates
A change in interest rates will affect bond prices.
When interest rates rise, bond prices will fall. Bond yields and prices have an inverse relationship.
For example, let’s assume you were to buy a bond at par value of $100 for a 5% annual coupon payment. Should the interest rate rise to 6%, your bond that issues a 5% coupon would no longer be worth the same $100 as investors could purchase other bonds that give a 6% coupon for the same $100. Therefore, your bond would drop in value to adjust for the lower yield to attract buyers.
Similarly, if the interest rate were to drop to 4%, then the value of your bond would go up to reflect the higher yield that your bond gives in the lower interest rate environment.
In both scenarios, assuming the bond issuer continues to pay the fixed coupon regardless of the external interest rate environment, then there will be no loss to the investor (lender) if held to maturity. There would, however, be an opportunity cost in a rising interest rate environment, as the lender could get higher yielding bonds for the same investment.
Reason 3: High Inflation
Inflation has been rising over the last few months in many countries. And particularly in Singapore, core inflation reached 3.6% in May, a 13-year high.
Inflation reduces the purchasing power of all assets, especially cash and bonds. The coupon payments and principal amount will buy less than if there’s no inflation.
When inflation is high and bond yields are low, the real yield (inflation-adjusted) can be negative. Currently, the real yields are -5%, based on the US 10-Year Treasury rates.
Source: FRED Economic Data
What Is Causing Bond Prices To Drop In 2022?
To support its COVID-19-ravaged economy, the Federal Reserve (Fed) engaged in unlimited quantitative easing by purchasing $120 billion of bonds per month. It consisted of $80 billion in US Treasury securities and $40 billion in mortgage-backed securities and lasted until December 2021, when it was ended.
The “easy money” policy helped the U.S. economy bounce back from a recession but also led to the Consumer Price Index (CPI) to rise by 7% in 2021, which represents the largest change in the cost of living since 1981. This prompted the Fed to begin quantitative tightening to curb the rising inflation. However, the escalation between Russia and Ukraine, two major commodity exporters, has hastened the rise in inflation with soaring energy and food prices due to supply chain disruptions.
As a result, the Fed raised interest rates three times this year, signaling a more hawkish stance in 2022. The latest hike announcement in June 2022, by 0.75%, marked the largest increase since 1994. With the U.S. CPI reaching another new high of 8.6% in May, the Fed is expected to increase interest rates a few more times this year to halt the rise in inflation.
Given its inverse relationship, bond prices could continue to be negatively affected in a rising interest rate environment.
Are Bonds Still A Safe Asset Class?
Bonds might seem like a risky asset class, especially in the current economic climate of rising inflation and interest rates. However, bonds are still not as risky as stocks based on past data. The graphs below, which show quarterly stock returns since 1976, indicate that stocks have more and larger negative return quarters than bonds.
Source: S&P 500 quarterly returns, 1976 to March 31, 2022. Dimensional Fund Advisors Data.
Source: US Aggregate Bond Index, quarterly returns 1976 to March 31, 2022. Dimensional Fund Advisors Data.
How Should You Position Your Bond Investments In 2022?
Each asset class, be it stocks, bonds, or others, serves a function in an investor’s portfolio depending on their risk tolerance and investment objectives.
Similarly, bond investors who are facing paper losses due to the drop in bond prices could continue to hold the bonds (ie: individual corporate bonds or bond funds) and receive the coupon payments, provided the underlying issuer is financially strong and has no going concerns. Even though bond funds might reflect lower prices, the income received from the funds will continue to grow with higher yields from the fund’s new bond investments.
Additionally, investors who prefer to stick to bond investments could choose short-term (1-to-3-year) bonds as they are less sensitive to interest rate changes and may also help to mitigate price sensitivity in a portfolio should interest rates continue to rise.
Lastly, investors could also choose to invest in the Singapore Savings Bonds (SSBs) as they have no reinvestment risk. The SSBs, which are backed by the Singapore government, have no early redemption penalty fees, which allows you to buy-in to higher yielding bonds should interest rates continue to go higher.
Get The Latest Bite-sized Investment News, Ideas & Insights
Join FSMOne.com's Telegram channel ( FSMOne SG - Research Highlights ) to stay updated on the latest investment and personal finance news, idea and insights. Whether you're at home or on-the-go, this is a quick and convenient way to stay in-the-know.