Fixed income rarely enjoys the same amount of attention as its equity counterpart. And it’s not hard to see why. Discussing the terms of your IBM-issued bond doesn’t exactly lead to stimulating dinner conversation.
But a staggering $49 trillion is invested in U.S. bonds, which is a sum even our stock market can’t match. Make no mistake – the state of fixed income sheds great light into the American investor’s psyche.
Don’t believe me? Let’s look at the safest move an investor can make – a loan to the U.S. Government. A treasury.
A treasury investor’s options are displayed through a yield curve – this plots out the yields of government bonds with different end dates. Some contracts last a few months up to 30 years. In a normal market, investors receive a higher yield the longer they have to wait for a bond to mature. That’s pretty intuitive.
However, the relationship between yield and waiting isn’t always so simple. During unique moments in time, the script is flipped – the yield on 10 year U.S. Government bonds are less than the yield on 2 year U.S. Government bonds.
As you may have guessed, we aren’t living in ordinary times – Much of 2022 has been marked by a yield curve inversion.
In other words, demand for long-term bonds is increasing and the demand for short-term bonds is decreasing. In this scenario, investors believe that longer-term rates in the future will be lower, which usually happens because of a recession. So they want to lock in the rate now. You can view this move as a flight to safety.
Given that it preceded every U.S. recession dating back to 1955 (with one false alarm), the yield curve inversion has become something of a bellwether.
But why are investors so pessimistic? Well, change is in the air. Our economic policies are doing a 180. Borrowing isn’t free. Inflation isn’t transitory.
The Fed has increased rates during five separate meetings throughout this year. Just from March to September of 2022, the fed funds rate climbed from a target range of 0.25-0.50% to 3.00-3.25%. And keep in mind the market still expects two more rate hikes before 2023.
As rates continue to go up, bond prices go in the opposite direction. The U.S. Barclays Agg, which is basically the S&P 500 for fixed income, is down 15.69% so far in 2022.
Think about it – You hold a bond that pays 4%, and all of a sudden the market starts to issue bonds paying 6%. Any prospective buyer will insist on a discount to take this lower-paying bond off your hands.
The U.S. experienced a yield-starved environment for well over a decade – from 2008 to 2020, the yield on a 10 year U.S. Treasury steadily declined from an average of 3.7% to 0.9%. But even in this ‘lower for longer’ period, investors were encouraged not to snub bonds.
The conventional wisdom said, “New issues may not provide as much income as they used to, but bonds can still act as that ballast – you need something to zig when equities zag.”
Not to be outdone by the AGG, the S&P 500 has fallen by 25% YTD. So while bonds haven’t lost as much as stocks, these two markets being so deep in the red isn’t what the proponents of the 60/40 portfolio had in mind. There is no safe haven asset right now.
As losses mount and households see their wealth continue to decline, they spend less. Given that consumer spending makes up 70% of our economy, recession risk starts to creep up.
Now is the time to do a personal financial audit to ensure you’re set up to weather a potential recession.
If you’re still working, is your resume fully up to date in case you have to hit the job market? Is your emergency fund fully funded? Do you need the cash from one of your stock investments within the next 3-5 years? If so, understand you’re introducing more luck & randomness into your outcome. When looking at the stock portion of your portfolio, is it filled with high-flying growth stocks? Do you have steady dividend payers as a complement?
On the bond side, are you diversified across credit quality, issuers, and maturities? Not all bonds are created equal.
In other words, focus on controlling what you can control. This too shall pass.