Pull to par
Bond yields are still low relative to current inflation and to their history. As such, there isn’t much bullishness around fixed income. However, bond prices are at multi-year lows. That means there is the potential for some interesting returns in the next year. Bonds have sold off a lot and in previous bear market episodes, subsequent returns have been strong. So now is not the time to sell. In equity markets, de-rating continues and has been brutal in some parts of the market. At the headline level, we are getting to bear market correction territory. It is hard to call a market turn, but if the economy starts to show real signs of slowing, bonds will rally, the dollar will come off and eventually stocks will recover. At a minimum, markets are going to remain very interesting.
Regular readers will know I have been trying to address the question that everyone is asking – when is it time to get back in the market? At least for bonds. My comments in recent weeks have suggested scaling back in as yields moved higher. I re-iterated the view this week with some colleagues and at a conference where I was a panellist. Straight to the point – it is not a good time to bail out of bond markets.
Actually since I suggested this opinion to colleagues, markets have rallied. Nevertheless, I think the view still holds, at least from a tactical point of view. The key point is that bond prices have fallen a lot. We can see this at the index level. Some index providers report a weighted average price of all the bonds in the index. In recent years average prices have been well above 100 as interest rates have fallen below the coupon rates at which bonds were first issued. Indeed, the gap between the yield to maturity and the weighted coupon had fallen to a record low (yields well below coupons). That is now reversing, and prices have fallen accordingly. What this means is that by either replicating a benchmark index or constructing a more concentrated portfolio, there is the opportunity to buy lots of bonds well below par. On the assumption that most of them will redeem at 100, returns can be significant once the market turns. Pull-to-par, like compound interest, is one of the wonders of bond investing.
Rare price levels
Look at a few examples. One of the long-held favourite fixed income sub-asset classes of mine has been US high yield. Taking the Bank of America/ICE index as a representative benchmark, the average price has recently fallen to 90.6. There haven’t been many times in the past twenty years when the price has been lower – the COVID shock in 2020 (low of 78), the growth fears in 2015 (low of 84), the Global Financial Crisis in 2008-09 (low of 55) and the recession after the Y2k slowdown (low of 75). Each time, 12-24 month price returns were subsequently very strong. Prices may go lower, but they won’t stay low. Yes default risk is rising, but active stock selection means that at the portfolio level this risk can be mitigated. There are plenty of examples of low bond prices – even in the US Treasury market which has borne the brunt of Fed tightening expectations. The 7-10yr index is trading at a weighted average price of 87.8 – a record low for that particular index.
100 is the magic number
“But yields are still low” I hear you shout. That’s true, and in most cases they are below the current rate of inflation. The thing is, bonds get closer to 100 in price the closer they get to redemption. At the index level, returns will benefit from this constant pull to par and new bonds will be issued – with higher coupons – at 100. So the average price goes up. If interest expectations start to ease back this will provide an additional push higher in prices. The total return could significantly beat inflation over the next couple of years even if the yield-to-maturity (which represents the annualized total return over the remaining life of the bond) may not look as though that would be the case.
Peak in rates is still unclear
There is push-back to the view because there is no conviction that rate expectations have peaked. Interest rates are higher than they have averaged in recent years and could stay higher. The rally in prices may take longer as a result. Over the medium-term the focus should probably switch to those fixed income assets that can generate income that will be positive in real terms. Lower rated credit and some of the floating rate assets where credit fundamentals remain strong should do that. I also think that, with higher yields, safe-asset bonds (governments) can provide a better hedge in portfolios. There is no evidence to convince me that the structural negative correlation between returns from duration exposure (high quality government bonds) and risky asset returns (excess returns in credit and total returns from equities) has gone. The best hedge is long duration (30-year Treasuries, gilts or bunds) for the credit return part of a bond portfolio or the equity part of a multi-asset portfolio. If bond yields are higher, they have further to move down when markets are worried about recession, and the longer the duration of the bond asset, the more the total return will be.
Down and up
There is little conviction on the timing of a significant rally because the Fed might remain hawkish, and inflation may continue to run at its current rate for a few more months. Market expectation of the peak in rates could go higher again. Nevertheless, the return profile remains similar, it will just take longer. The US corporate bond market registered negative calendar year total returns in 1979, 1994, 1999, 2008, 2013, 2015 (small) and 2018 and each time the subsequent year saw strong positive returns. Returns were negative in 2021 as well and this year may be the exception to the positive bounce back given that we are at something of a regime change in the interest rate cycle. But that strengthens the conviction for positive returns ahead.
Equities still de-rating
Calling the turning point in equities is much more difficult because there is not the same valuation anchor as in fixed income. This week saw the S&P500 fall below 4,000. A few months ago I wrote that my simple equity risk premium model suggested that the market would go below this level on the basis of Treasury yields rising. At the time I was thinking 2.5% for bond yields but that still delivered a sub-4000 index level for equities. As yet, there has been no degradation of forward earnings forecasts. If that does happen as the economy slows – and watch the ISM index as the key barometer of that – then equity prices could fall further. If they do, of course, it strengthens my more positive view on bonds.
Dollar dominance, for now
I’ll finish by saying something about the dollar. It’s clear that dollar strength, high prices for commodities and US interest rates are inextricably linked. People need more US dollars to pay for higher dollar commodity prices. Speculators bet the dollar on interest rate differentials. This is not likely to change until either commodity prices reverse – signalling a peak in inflation, and the Fed becomes less hawkish. In the meantime, it suits the US rather than the rest of the world, which is importing inflation. European producer price inflation is running at more than twice the US annual rate. It’s not surprising then that the ECB is set to raise rates in July rather than wait longer. Emerging markets are also suffering from a stronger dollar as it pushes inflation and interest rates up. That is not good for growth, and it is exacerbating the social concerns around food and energy prices seen vividly in places like Sri Lanka. It’s too early to bet against the dollar but when growth slows and the rates cycle turns, the dollar is likely to weaken from its lofty current levels. Against the other majors, it is not quite as strong as it has been in the past, but compared to recent years it is and the historical pattern is very much one of what goes up always comes down (by the way, see Bitcoin!).
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