Bonds are back
Reasons for bond optimism
Bond investors have experienced swift and deep losses in their portfolios over the course of the past year since the Bank of Canada, Federal Reserve, and other major central banks started hiking interest rates in their fight against inflation. However, bond investors should remember the fundamental role of bonds in a multi-asset (including stocks and bonds) portfolio, to serve as a ballast against higher market volatility in stocks.
That said, recent positive correlation observed between the two asset classes has perplexed investors about the utility of bonds in a portfolio. In this article we discuss two arguments: (1) Why rising interest rates will help drive higher returns for bond investors; and (2) Why we believe the positive correlation between stocks and bonds in 2022 is a unique one-off event and not indicative of a broader trend.
1. Coupons and their reinvestment are a major part of total bond returns – focus on income not just the price of a bond
Bonds are unique in that their returns consist of two parts: price return and coupons or income return. The income return comprises the compounded interest on bond coupon payments.
Long-term investors should consider the combination of these two components instead of solely concentrating on bond price returns. When interest rates fluctuate, the two components tend to move in opposite directions. Therefore, while higher rates may have a negative impact on bond prices in the short term, long-term investors will benefit by reinvesting and compounding at higher yields in the future. Figure 1 demonstrates that the income return, rather than the price return, has been the primary driver of bond investment performance over the long term when looking at Canadian, U.S., and global aggregate bonds.
Equities and bond bear markets are different
As time goes on, the impact of the price return component on total return decreases for bond investors, while for stock investors, the price return component can be much more significant. This is exemplified in the “lost decade” between January 2000 and December 2009, during which negative price returns caused by bear markets had a significant effect on S&P 500 total returns, culminating to -0.9% annualized total return, including dividend reinvestment.
However, the bond bear market of the 1970s, although challenging due to rising inflation and nominal interest rates, provides a distinct perspective when considering the current investing climate. Investors who reinvested their income returns and exercised patience as compounding took effect, nearly doubled their capital in nominal terms from 1976 to 1983. Over the long term, bond total returns are primarily influenced by the reinvestment of interest income and compounding rather than price returns.
Investors must look beyond the immediate losses reflected in their quarterly bond portfolio statements and focus on the potential long-term benefits of rising interest rates.
Bonds offer more advantages than cash in the current environment.
The power of compounding enhances during periods of high interest rates. By staying invested in bonds, investors benefit from both higher yields and their reinvestment or compounding effect. Many advisors have favored cash and cash-equivalent bonds in recent years, fearing the potential impact of rising rates. The strategy has worked, briefly, as cash and very short-duration securities are much less sensitive to interest rate increases. But continuing to overweight cash may prove to be another example of how what worked in the past may not work so well again in the future.
Consider the tradeoffs of maximizing yield today by overweighting cash or very short-term bonds in the inverted yield curve environment compared with moving out the curve to take advantage of yields higher than they have been since the global financial crisis and better defend your portfolio from equity weakness.
2. Higher coupons mean lower duration or sensitivity to interest rates
When we look at the duration of a bond, we consider its price sensitivity to changes in interest rates. So, the lower the duration of a bond, the less sensitive its price is to movements in interest rates, and vice versa. Bonds with higher coupons have lower duration, compared to similar maturity lower coupon bonds, because they receive proportionately more coupon payments or cashflows until maturity. In other words, higher yields offer a greater cushion to absorb the shock of interest rate changes without leaving investors with large losses.
And therefore, initial or starting yields make a difference.
Initial yields make a difference
The initial or starting yield of a bond determines the performance of a bond investment. For example, short-term Treasuries are vulnerable to interest rate changes, and their total returns are most affected by changes in central bank policy. Due to adjustments in Federal Reserve policy, the interest rates on the short end of the Treasury yield curve have risen, causing an increase in the weighted average yield to maturity for funds that invest in these securities.
This provides a more robust foundation to withstand any further rate shocks, as initial or starting yields are now much higher. Even if rates were to rise by an additional 200 basis points from the current level, investors would recoup any lost principal within a year and benefit from higher yields moving forward, ultimately increasing the long-term value of their bond portfolios as illustrated in Figure 3.
Therefore, we can conclude that the time it takes to recoup one's capital from an interest rate shock is determined by the initial yield. A 200 basis point (bp) rate shock from a 75 bp initial yield will take longer to break even than a 200 bp rate shock from a 450 bp initial yield. Furthermore, if an investor's time horizon is longer than bonds’ portfolio duration, they should favor rate increases over rates remaining constant.
The bottom line is that as rates and yields move higher, bonds are more attractive, not less.
Next time: Three more reasons why bonds are back: improved yields; portfolio ballast; positive stock-bond correlation not long-lasting.
Bilal Hasanjee, CFA, MBA, MSc Finance, is Senior Investment Strategist at Vanguard Investments Canada.
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