We’ve just entered the fourth quarter of 2022 and already it’s shaping up to be the worst year for stocks since 1969 and the worst year for bonds ever. The S&P 500 is in a bear market, down 23% year-to-date while the Bloomberg U.S. Aggregate Bond Index, which is the most widely used benchmark for the investment-grade U.S. bond market, has tumbled nearly 16%.
If both indexes close out 2022 in the red, it will be the first time that has happened since 1969. That’s not how a balanced portfolio made up of stocks and bonds is supposed to work. In a so-called normal year, bonds and stocks have an inverse relationship. Typically when stocks tumble, bonds act as a stabilizer.
That’s not happening in 2022. Which means investors don’t have a lot of places to park their money.
What’s Happening to the Bond Market?
Historically, for both stocks and bonds to crater in the same year something major needs to be going on. For example, in 1941 the broader markets took a hit when the U.S. entered World War II.
Soaring inflation in the mid-1960s forced the U.S. Federal Reserve to aggressively hike its interest rates in an effort to cool the economy. It worked. In 1969 as the economy tipped into a recession, and stocks and bonds ended the year in negative territory.
There’s an eerie similarity between what happened in 1969 and what’s going on in 2022. During the 2020 pandemic, the Federal Reserve, and other central banks around the world, artificially lowered their interest rates to near zero. Lower interest rates make it cheaper to borrow, which in theory, prevented the U.S. economy from crashing.
While artificially low interest rates make it cheap to borrow money, they also gut investing and retirement portfolios. Especially those that rely on fixed income investments like bonds and treasuries.
In effect, the Federal Reserve and other central banks effectively removed income from income investing. With inflation soaring, central banks need to play catch up, which has resulted in unprecedented rate hikes. And that’s been bad news for short-term bonds.
Why does that matter?
Bonds and other fixed income securities are supposed to be a safer investment for those seeking to limit the risks associated with the stock market. With a global recession expected in 2023, investors have been seeking shelter from stock market volatility. But with bond yields rising and prices falling, investors are feeling the punch.
How Do Bonds Work?
The idea of investing in bonds seems, on the surface, pretty straight forward. But the fact is, bonds and bond pricing can be very confusing.
First, it’s important to understand that bond prices and yields have an inverse relationship.. The yield is tied to the bond price; when bond prices rise, the yield falls and when bond prices fall, the yield rises.
A typical bond has a face (or par) value of $1,000, a coupon rate, and a maturity date. The coupon rate is just the fixed annual rate (interest rate) that a guaranteed-income investment, like a bond, pays the owner of the bond.
If you buy one $1,000 bond with a two-percent coupon rate that matures in 10-years, you will receive two percent interest on the $1,000 bond twice a year, for 10-years. After the 10-years, you sell the bond back for $1,000 and keep the interest you’ve accumulated during that time.
It’s the buying and selling of bonds on the secondary market that gets confusing.
Here, the par value of the bond can change due to supply and demand dynamics. This is especially true in an environment where interest rates are rising or plunging.
If you owned a 10-year bond with an interest rate of two percent and the Federal Reserve raises its rates, bond yields have to rise to keep pace. If new 10-year bonds have an interest rate of four percent, you’ll want the bond that pays the higher coupon rate.
To get the bond with four percent you’ll need to sell the two percent bond for less than its par value. If you hold onto that four percent bond until it matures, you’ll earn four percent plus the difference between the $1,000 face value and the purchase price. The combined amount should come out to around four percent, which is the new bond rate.
This scenario holds true if bond yields go lower. In the above scenario, the holder of the four percent bond could sell it for above the face value.
Should I Invest in Short-Term Bonds?
Bonds are having a bad year, but they should still hold a place in your portfolio, especially if you have a longer investing timeline. The type of bond to consider is what might change. With interest rates on the rise, bond prices fall, which negatively impacts investors’ returns.
When there is ongoing uncertainty, investors turn their attention to long-term bonds because they get a specific return over a longer period of time. This results in an inverted yield curve, which is where yields are higher for short-term bonds than longer-term bonds.
Because of uncertainty and volatility, investors also tend to avoid the stock market and instead pay attention to bonds, where they are guaranteed a specific return with little downside risk to the principal.
What Are Some Alternatives to Short-Term Bonds?
If you are a short-term investor or are seeking a reliable income stream, there are alternatives. In fact, soaring interest rates and falling bond prices has created a great opportunity for investors to rebalance their portfolio with better fixed-income strategies.
This could include:
- Moving to a more aggressive portfolio mix of stocks and bonds; instead of 60-40, move to 70-30
- Short-term bond funds, in particular, those that hold corporate bonds instead of those that use government debt
- A cash alternative exchange-traded fund (ETF), also known as high interest savings funds, do not hold bonds, instead, the assets are placed in bank savings accounts with higher rates of returns than what retail customers receive
The Bank of Canada and U.S. Federal Reserve have both said additional rate hikes are coming and are expected to remain elevated well into 2023. Central banks will only reduce their interest rates when inflation starts to fall. Investors looking for above-average gains and below market volatility may consider cash alternatives to short-term bonds.
Looking for Cash Alternative Investments?
Cash has always been an important component of a well-diversified portfolio. The cash portion of a portfolio helps preserve capital during market downturns and may act as a temporary hold until new investment opportunities become available. Evolve’s cash solutions can help preserve capital and liquidity by investing in high-interest deposit accounts with some of Canada’s big six banks. Maximize monthly income with high-interest savings ETFs.
High Interest Savings Account Fund (HISA ETF) offers daily liquidity and an attractive 4.24% yield* in Canadian dollars. To learn more about investing in HISA ETF, click here: https://evolveetfs.com/hisa/
US High Interest Savings Account Fund (HISU ETF) offers daily liquidity and an attractive 4.20% yield* in U.S. dollars. To learn more about investing in HISU ETF, click here: https://evolveetfs.com/hisu/
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