Climbing Up the Interest Rate Mountain

BY | June 7, 2022

2022 has been a challenging year for stocks; however, the real pain can be felt within the bond markets. The chart below illustrates that bond markets are currently in their worst drawdown in over 40 years.

Figure 2 - Avantis Investors

Figure 2 – Avantis Investors

I’d like to address two common concerns our clients are facing within their fixed income portfolios:

  1. If rates continue to rise, does that mean the stock & bond market will continue to lose value?
  2. Are bonds still worth holding in a portfolio going forward given the Federal Reserve’s intentions and YTD performance?

Question #1:

The market is a forward-looking machine that takes current information, assigns probabilities to various outcomes and values these random outcomes into current stock and bond prices. In other words, the drastic decline in bonds so far YTD are representative of capital markets pricing in multiple future rate hikes from the Federal Reserve. Our partners at Avantis studied whether past changes in yields had a forward-looking impact on bond market returns.

The results are illustrated below:

Figure 3 - Avantis Investors

Figure 3 – Avantis Investors

At first glance, we can clearly see that there is randomness in the results. The graph illustrates that prior recent yield changes provided little guidance on future bond market returns. This is exactly what we would expect in an efficient capital market system where future expectations are already priced into securities.

Another sign of market pricing power is observed when we look at both equity and bond market returns during past rate hike cycles. Again, we see that both asset classes have managed to produce positive long-term returns during a Federal Reserve rate hike environment1:

Rate Hike PeriodStocksBonds
January 1983 – July 19849.45%7.53%
December 1986 – April 198919.77%5.54%
January 1994 – January 19955.58%-1.75%
May 1999 – May 20209.01%2.20%
June 2004 – May 200615.17%2.12%
December 2015 – December 20186.37%1.11%
Average10.89%2.79%

We can give a resounding NO for an answer to our first question on avoiding stock and bond markets given the current economic picture. Avoiding an asset class because of current macroeconomic news has historically been a poor bet for long-term investors.

Question #2:

What if I told you that bond holders are wealthier right now than they were at the start of 2022? Most would laugh at me; however, this is a true statement and highlights a point that investors should recognize. Bond values have declined in 2022 leading to higher yields and a bond’s yield is the largest component of its return going forward. Let’s examine what this means for bond holders by looking at the shift in U.S. yield curves:

Figure 4 - Avantis April Field Guide

Figure 4 – Avantis April Field Guide

At the start of 2021 we can see that the 5-year treasury bond was yielding around 1.25% annually. 4 months later we can see a shift in the curve showing that the 5-year treasury bond is yielding just under 3% annually. Basic bond mathematics tell us that a 1.75% rise in rates should produce roughly a -8.43% loss on a 5-year treasury bond. Here is where things get interesting, investors are now picking up an additional 1.75% yield annually. Each year going forward, our 5-year treasury pays us 1.75% more in interest than it did at the start of 2022 which equates to an 8.75% gain in total return compared to the 5-year Treasury bond to start 2022. The chart below illustrates what is going on here:

5 Year U.S. Treasury Bond
Jan 1, 2022April 30, 2022YTD lossAdditional Yield5 Year Additional Yield
1.25%3%8.43%1.75%8.75%
(1.75% x 5 years) = 8.75% of cumulative returns
We have taken an 8.43 % price cut to today in order to gain 8.75% in future interest

Bond investors loss in present value is overtaken by the gain in future value. As investors, future value is what matters most for determining our spending power. It is strange to say, but bond investors have gained future real wealth so far in 2022. To answer our question, YES – bonds have a place in a portfolio for clients who need to control their risk and meet near-term spending needs.

Conclusion

  1. If rates continue to rise, does that mean the stock & bond market will continue to lose value? – NO
  2. Are bonds still worth holding in a portfolio going forward given the Federal Reserve’s intentions and YTD performance? – YES

The investment managers we partner with in fixed income apply a systematic rules-based approach to constructing a diversified bond portfolio with the freedom to adjust their exposure to credit risk and interest rate risk over time given market dynamics. Feel free to reach out to us if you have any questions or concerns regarding your fixed income allocation and we would be happy to share further details on 2022 performance and what this means going forward for your financial plan.

1Stocks are proxied using MSCI World Index (gross dividends) / Bonds are proxied with Bloomberg US Government Bond Index Intermediate-term

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