Few investors need reminding that stocks are having a rotten year. But the slump in equities is a mere tremor compared with the tectonic shifts underway in the bond market.
Bonds globally are on a losing streak for the ages, with some benchmarks of performance posting their worst numbers ever recorded in a calendar year.
The Bloomberg U.S. Aggregate Bond Index, a widely used proxy for investment grade government and corporate debt, is down by 16.3 per cent year-to-date. That’s twice as bad as the next worst year in the U.S. credit market, which was 1969 when a comparable benchmark lost 8.1 per cent, according to Vanguard Group data going back a century.
Around the world, bond yields have soared, which tends to happen when the appetite for owning bonds shrinks – declining investor demand drives bond prices down, which translates to higher yields. On Thursday, the yield on 10-year debt issued by the U.S. government rose to 4.2 per cent, its highest since the global financial crisis nearly 15 years ago.
The signs of tumult are spreading across the credit world. In the U.K. and Japan, central banks have recently intervened to try to contain bond market dysfunction. And measures of volatility are close to levels reached in previous crises.
This is not how bond markets are supposed to function. As an asset class, bonds are often expected to provide stability, especially when economic cracks are forming.
What bond investors are experiencing is a violent snapback from the vast distortions of pandemic-era economics, said Laurence Booth, CIT chair in structured finance at the University of Toronto’s Rotman School of Management. The unique pressures of the COVID-19 crisis compelled central banks to buy astonishing amounts of bonds, what is commonly known as “quantitative easing.”
The bonds sitting on central banks’ balance sheets globally ballooned to US$36-trillion – nearly 30 per cent of the total value of bonds outstanding. This type of stimulus served to stabilize financial markets and keep interest rates as low as possible.
“If all of that debt had not been bought, interest rates would have been sky high,” Mr. Booth said. “So we’ve got an anomaly engineered by the central banks which is now beginning to correct.”
The catalyst for that correction was, of course, inflation. Until recently thought to be banished to the 1970s, the reappearance of rampant inflation has upset 40 years of bond market dynamics.
Bonds really don’t like inflation. A bond entitles its holder to a series of payments at fixed points in time, hence the term “fixed income.” Inflation erodes the value of those future payments. The further out those payments stretch, the greater the corrosive effect, which is why long-term bonds have been especially hammered this year. The iShares 20+ Year Treasury Bond ETF, for example, is down by a whopping 36 per cent.
Desperate to get inflation under control, central banks are putting pressure on the bond market in two ways. First, by starting to unload their stockpiles of bond holdings, putting downward pressure on prices. And second, by a simultaneous global campaign of rate hikes that would have been unfathomable just a year ago.
Global rate hike scorecard
Policy rate moves, 2022
Year-to-date change, percentage points
Central bank policy rate
Current rate
New Zealand
+2.75
3.50%
Canada
3.25
+3.00
U.S.
3.125
+3.00
+2.50
Australia
2.60
Britain
2.25
+2.00
Norway
2.25
+1.75
Sweden
1.75
+1.75
+1.25
Euro zone
1.25
Switz.
0.50
+1.25
Unchanged
Japan
-0.10
4
-1
0
1
2
3
the globe and mail, Source: bmo financial group
Global rate hike scorecard
Policy rate moves, 2022
Year-to-date change, percentage points
Central bank policy rate
Current rate
New Zealand
+2.75
3.50%
Canada
3.25
+3.00
U.S.
3.125
+3.00
+2.50
Australia
2.60
Britain
2.25
+2.00
Norway
2.25
+1.75
Sweden
1.75
+1.75
+1.25
Euro zone
1.25
Switz.
0.50
+1.25
Unchanged
Japan
-0.10
4
-1
0
1
2
3
the globe and mail, Source: bmo financial group
Global rate hike scorecard
Policy rate moves, 2022
Year-to-date change, percentage points
Central bank policy rate
Current rate
New Zealand
+2.75
3.50%
Canada
3.25
+3.00
U.S.
3.125
+3.00
+2.50
Australia
2.60
Britain
2.25
+2.00
Norway
2.25
+1.75
Sweden
1.75
+1.75
+1.25
Euro zone
1.25
Switz.
0.50
+1.25
Unchanged
Japan
-0.10
4
-1
0
1
2
3
the globe and mail, Source: bmo financial group
The problem is that inflation itself isn’t co-operating, with food and shelter costs continuing to rise. Last week, Bank of Canada Governor Tiff Macklem called inflation “the most immediate threat to current and future prosperity.”
The growing realization that the volatility in financial markets will not sway central bankers from their inflation-fighting mission led to a fresh round of bond market negativity this week. The U.S. 10-year benchmark yield is on track for its 12 consecutive weekly increase, which would set another dubious record in the bond space.
All of which puts everyday investors in a bit of a pickle. The whole point of putting a meaningful component of one’s retirement savings into bonds is to diversify – essentially to offset losses when stocks correct. But that doesn’t really work when bonds and stocks move in the same direction as they are now.
The 60/40 stock/bond split that has served as a model portfolio for many investors is having an historically terrible year as a result. “The argument in favour of the standard 60/40 portfolio is nowhere near as strong now,” said Ian Pollick, managing director and global head of fixed income, currency and commodities at CIBC Capital Markets. “The return on bonds is going to continue to go down.”
The threat of a global recession would normally see investors flocking to safe fixed-income, pushing prices up and yields down. Inflation has changed everything, bringing an abrupt end to an era of low inflation and declining interest rates stretching back to the early 1980s.
The calculus for bond investors has been transformed. The idea that government bonds provide a safe haven to investors in a recession is “obsolete,” institutional investor BlackRock said in a research note this week. It cited the recent experience in the U.K., where a proposed tax cut spooked investors and sent bond yields soaring.
There is a silver lining for investors – two of them, in fact. The first is that long-term returns for bonds now look much more attractive than they did a year ago, especially if one gets into the market now. As in the stock market, a major sell-off can reset expectations for the years ahead.
And the second is that fixed-income products are finally delivering a decent yield. “For the first time in a very long time, fixed income is doing what it’s supposed to do – providing people with fixed income,” Mr. Pollick said.
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