Bonds: A worthy investment today
Staying The Course
May 6, 2022While the stock market, geo-political developments and everything Elon Musk usually grabs the headlines, we must take some time now to discuss the bond market and interest rates.
Being mostly comprised of institutional investors, the bond market is usually seen as being “smart money” and therefore also functions as a leading indicator of the economy. The bond market affects the economy as investors essentially determine what interest rates will be for a given time horizon (This is called the yield curve). This then makes its way into the cost of housing mortgages or car loans. So the higher interest rates that the bond market is projecting the more expensive it is to borrow money.
So why increase the cost of borrowing money? Enter, inflation.Back in 2020, as the pandemic basically shutdown world economies, Central Banks globally would have slashed interest rates, thereby making it cheaper to borrow. Additionally, the process of Quantitative Easing also made more cash available for lending. This was the chosen course of action in order to keep the economy running on some levels as opposed to a full-fledged economic halt and lapsing into any prolonged recession.
Now the story has changed and The Fed is battling with a different beast all together. As the Ukraine – Russia war continues, prices of hydrocarbons, commodities and metals have skyrocketed. To add to this, supply chain issues are still not sorted. Household spending and business fixed investment remained strong, the unemployment rate has declined and annual inflation rate came in at 8.3% in April 2022, much higher than the Fed’s long run target inflation of 2.0%. So in order to cool a boiling hot economy the Fed needs to raise interest rates (increase the cost of borrowing money), which will help in some ways. The problem this time around is that some of these inflationary pressures are very much external to the US. So the Fed needs to tread lightly as if rates are increased to quickly and external influences are sorted, it could have the negative effect of pushing the economy back into a recession.
So since the start of 2022, the Fed has raised rates twice. Firstly in March by 25bps and then in May by 50bps, bringing the current Federal Funds rate to 0.75% - 1.00%.
The table and chart below shows that rates have increased across all tenors since the start of 2022. Also with some shorter term rates increasing faster than longer term rates the yield curve’s shape is a bit flatter and is a sign of economic uncertainty ahead.
For the next 3 months US Treasuries (UST) and Mortgage Backed Securities (MBS) will be capped at $30 billion and $17.5 billion respectively after which they will then be capped at $60 billion and $35 billion respectively. What this means is that the Fed will not be reinvesting funds it is receiving from maturities unless the principal maturing exceeds the monthly cap, thereby having an overall measured effect of taking money out of the market. As such a big buyer is being removed from the market, rates will now be more reflective of what fixed income investors are thinking.
What to expect in the near future?The current rhetoric from the Fed is that we can expect more rate increases in 2022 and a measured balance sheet run off in an effort to strangle excess inflation. The increased rates will lead to higher yields and lower bond prices. However, not all bonds are created equally.
The fixed income universe is broadly divided into Investment Grade (IG) and High Yield (HY) securities and interest rate changes will have a different effect on each of these. IG securities are usually favoured during tough economic times while HY bonds are favoured during strong economic times.
IG portfolios have more exposure to interest rate risk and changes in the values of these portfolios can be estimated using duration. So as rates increase we can expect the values of these portfolios to fall.
HY portfolios also possess interest rate risk which will push prices down, but also possess larger credit spreads which tend to be negatively correlated with interest rates. This is because rates usually rise when the economy is expanding, which means increased consumer sentiment, increased spending and higher profit margins. This also leads to lower default rates which reduce credit risk. Shrinking credit spreads leads to an increase in price. So for HY portfolios we’ve got one effect pushing prices up and another pushing prices down.
Additionally as rates increase, money managers will be lured into the high yield space by the attractiveness of now higher, steady returns and low correlations with other asset classes, thereby reducing portfolio volatility. This will pull monies away from other asset classes and into the fixed income space. So as rates increase, high yield bond prices can fall, but usually rebound quickly as the higher yield is taken up by the market.
Conclusion
While investors are fearful of the impact on Bond Markets due to rising interest rates, it is worthwhile to remember that investment grade bonds provide some level of stability and liquidity within an investment portfolio. High Yield Bonds, while considered slightly more risky due to their credit quality, generally provide higher returns and portfolio diversification. Year to date (27th May 2022) we have seen HY bonds returning -8.62% while IG bonds have returned -8.52% (according to Barclays Bond Indices). We continue to monitor the impacts on Bond Markets as the Fed raises interest rates and its impact on economic growth. In order to mitigate interest rate risk, we are placing our portfolios in shorter duration buckets.
Written by: Vincent Dipchan CFA, BSc
Reviewed and Edited by: Shala Singh CFA, BSc
Reviewed and Edited by: Keshala Mahabir CFA, ACCA