Rates up . . . Bonds Down
May 9, 2022
Volatility has returned to the market this year – in some expected places, and in some not so expected places.
Equity investors are (or should be) used to volatility. The two steps forward, one step back pattern of the stock market often drives long-term outperformance. You are paid for accepting risk. When it comes to bonds, though, most investors expect a slow, steady return. They are willing to sacrifice upside for lower risk. In a rising rate environment – which we haven’t seen since the early 1980s – that may not be the case.
The stock market is off so far this year, led down by the Nasdaq, which is in a bear market (down over 20%). We had suggested in previous newsletters that many of the high-flying tech stocks were trading at extraordinary valuations. As inflation jumped and the Fed began raising rates, at the risk of the economy’s health, the market has started to reassess those valuations. The bright side is that value stocks and defensive sectors, where Allied remains overweight, have held up better than the major indexes.
On the other end of the perceived risk spectrum, there are areas of the bond market seeing their worst drawdown in over 40 years. The 20+ Year Treasury Bond ETF (TLT) is down roughly the same as the NASDAQ. While there are parts of the fixed income market holding up better (areas where Allied is currently positioned), this downside volatility is taking some people by surprise. The lower risk component of their portfolios is falling as fast as the Nasdaq index.
The reason for the drop is due to the inverse relationship between interest rates and bond prices. We think of it like going to the grocery store and buying a tray of 5 cookies for $1.00. You go back to the grocery store tomorrow and see they are now selling a tray of 6 cookies for $1.00. This means your 5 cookies are no longer worth $1.00. The same is true for bonds. When you buy a bond with a 5% yield, and then interest rates go up to 6%, your bond is no longer worth as much. That is what we’ve seen so far this year. With inflation forcing interest rates higher, we are seeing sharp drops in bond prices.
This is particularly true for long maturity bonds. The longer the average life of a bond, the more interest rate risk you are taking. The 20+ year Treasury ETF (TLT) is an index at the far end of the maturity spectrum. It is down -22.8%. Other funds with longer-term focus are also getting hit. The Preferred and Income Securities ETF (PFF)1 is down -14.8% year-to-date. The Nuveen AMT-Free Quality Municipal Fund (NEA)2 is down -21.2%. Even the TIPS Bond ETF (TIP)3, which is designed to move with and protect against inflation, is down -6.7%.
This compares to the 1-3 Year Treasury Bond ETF (SHY), which holds short maturity bonds. It is only down -3.0% this year. With our view that the low interest rates of recent years didn’t justify taking on extra interest rate risk, we have been, and continue to be, positioned in short maturity bond funds.
One nice thing about bonds, though, is that if you hold to maturity, you are promised to earn the yield at which you bought (outside of default). If you buy a bond at a 5% yield, even if rates jump up to 10% and you see a large interim loss in your portfolio, if you hold to maturity, you will still earn 5%. Sort of like our tray of cookies – no matter how the grocery store prices cookies in the future, we still have the original 5 we bought.
While we’ve been happy to sidestep some of the volatility and significant drawdowns so far in 2022, there have been a few good reminders:
- Positioning matters – even in bonds. People spend a lot of time thinking about and repositioning their equity exposure: from growth to value, domestic to international, down to specific sector exposures. The same is true for bond allocations: understanding where the risks lie in terms of credit risk, interest rate risk, and maturity risk are all key.
- There is value in diversification. People who concentrated in growth stocks are feeling pain this year, as are people who put everything in long-maturity bonds. Diversifying amongst a handful of asset classes and sectors can add value above those of the individual components.
- The market is built on transferring risk. You need to know where it is. That is why we never invest in an instrument unless we view a “margin of safety” in the valuation. Buying a high-flying tech stock at 50 times revenue or a 30-year Treasury bond at 1.2% yield have little room for things to go wrong – no margin of safety.
As we move into the summer months, we plan to:
- Continue to hold high-quality value stocks. Relative valuations continue to look attractive, and we’re happy to own quality companies with good long-term prospects.
- Actively look for opportunities in this sell-off. So far, few of the sold-off names have the quality or valuation we require. But we also know that performance in the next market cycle will be driven by how we position in this downturn, so we’re actively looking for names with good margins of safety.
- Continue to focus on high-quality, short-term bonds. Interest rates are rising, making intermediate (3-7 year) maturities look more attractive. At this point, however, we still feel rates haven’t climbed enough to justify taking on the extra maturity risk, especially in an inflationary environment. We will continue watching closely for opportunities in this volatile bond market.
If you have any questions about your account(s), or if there has been a change in your financial situation or investment objectives, please feel free to contact any member of our team at (406) 839-2037 to schedule a meeting.
1 Preferred securities are equites with bond-like features and often long, or even perpetual, maturities.
2 NEA is a closed end mutual fund that invests in investment grade municipal bonds.
3 TIPs stands for Treasury Inflation Protected securities. These are Treasury bonds that adjust their coupon level dependent on the rate of inflation (as measured by the Consumer Price Index).
Data Sources: Koyfin (data as of 5/6/22)