Interest rates across countries have been moving up with unusual speed over the past four to six weeks, leading to sharp declines in the market values of a range of bonds. While 2022 has been one of the worst years for fixed income performance in memory, the activity of the past month stands out as uniquely stark.
As of the time of authorship, in September alone, 2-year Treasury yields are higher by +0.72% while 10-year Treasury yields are higher by +0.57%. Assuming the last several days of September fare similarly, this move will mark the third month of 2022 in which the U.S. bond markets fell in aggregate market value by 3% or more.
The reasons for the increase in interest rates and the commensurate decline in bond prices so far in 2022 are several-fold:
- Higher-than-expected inflation is eating into returns, leaving bond buyers to demand higher interest rates to compensate for that inflation. Inflation will probably slow in the coming months, but it has proven frustratingly high so far.
- The Federal Reserve is raising overnight interest rates at the fastest pace since 1982. Although overnight interest rates are not onefor-one connected with longer-term interest rates, they are related, and higher Fed rates mean higher bond yields and lower bond prices.
- Developments in overseas markets have increased the (expected) supply of global bonds and pushed rates up and prices down as a result. The most obvious such development is the United Kingdom’s recent government proposal to cut taxes and run a large deficit funded with heavy bond issuance.
Individually, any of these factors might be significant, but together they have proven dramatic. That’s the bad news. The good news, however, is that fixed income is generating far more income than when 2022 began. New dollars invested in a hypothetical high-quality, A-rated, 5-year corporate bond are earning about 5.00% today, compared to about 1.75% at the beginning of the year. Interest rates on new dollars invested in U.S. fixed income markets are the highest since 2011 (excluding a few crisis weeks). Going forward, income generation should blunt the impact of further increases in yield and further declines in market value.
A little bit of bond math can help explain why. In rough terms, when interest rates rise 1%, a 5-year bond declines in market value by a little less than 5%. For example, a 5-year bond that was trading at $100.00 will be trading at roughly $95.25 after a 1% increase in interest rates. When interest rates are low, the yield on that bond is a small portion of the market value loss. However, when interest rates are relatively high, as they are now, the yield is a large portion of that market value loss. In the above hypothetical example, yes a 1% increase in interest rates will generate a nearly 5% decline in market value, but the yield on that bond will generate about 5% per year, essentially “protecting” against some of that market value loss. The loss protection feature of higher income generation is particularly powerful when deployed as part of a bond ladder in which regular maturities provide opportunities to reinvest at higher yields, even when maintaining that disciplined approach seems difficult.
The 2022 fixed income markets have been incredibly frustrating. Perhaps the biggest source of frustration is that bonds, so far, haven’t done what they are “supposed” to do in balanced portfolios. Instead of providing stability and protection, bonds have contributed to portfolio losses from the equity bear market. Although frustrating, the forward-looking outlook for fixed income, both as a standalone sector and as part of balanced portfolios, is significantly more appealing than at the beginning of 2022. Interest rates could still rise further from here, but in the meantime, patient investors are fairly compensated for that prospect.
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