If you have ever watched a basketball player closely, you will notice the best ones are as comfortable taking layups with their non-dominant hand as their dominant hand. I remember our coach used to design drills around getting us comfortable taking layups, or other close shots, with our “off-hand.” Fortunately, social media was not a thing when I was growing up, because otherwise there probably would have been some pretty funny footage of me learning to shoot with my left hand. Through much repetition, layups eventually became just as natural to shoot left-handed as right-handed. For investors, you may find yourself experiencing something that feels just as abnormal as shooting a basketball left-handed was for me…volatility in the bond market.
Bond Market Volatility
Most investors are well-conditioned for volatility in the stock market. Look no further than our February video to get our thoughts on the current stock market volatility. Long-time stock investors are used to large swings in the stock market; however, bond investors are used to “ebbs and flows.” Unfortunately, the first quarter of 2022 has not been kind to bond investors, and it may have been a shock to conservative investors. The aggregate bond index was down almost 6% for the quarter–its worst quarter in over 20 years! For comparison’s sake, the S&P 500 was down 5.33% for the quarter, which means the average bond investment performed worse during the quarter than an aggressive stock investment.
To help put the current volatility in proper perspective, it helps to understand how bonds work and look at the bond environment for the last 40 years. If you were to see a simple picture of a tree with no leaves, you may think the tree is dead. However, if you were to zoom out on the picture and see the surrounding landscape you might see snow on the ground. That context provides you with the idea that the tree is not dead but just dormant for the winter. In the same way, if you examine the broader context of the bond environment for the last 40 years, you will see prior years were favorable, and understand why bonds are currently struggling.
The simple math on bonds is this–when interest rates fall, bond prices rise, and the reverse is also true. I have a chart that shows in the early 1980’s you could get a government-issued savings bond with an interest rate of 15.21%! Some conservative investors may wish they could see those days again, but at the same time, the average 30-year fixed-rate mortgage was 18.63%! Today those numbers look like 2.7% for a 30-year treasury bond and a 30-year mortgage rate for around 4.8%. For essentially the last 40 years, interest rates have been falling, which has boosted bond prices.
However, since the beginning of the year, interest rates have been rising. The 2.77% 30-year treasury bond I just quoted above started the year at 2%, which is a 3.5% change. While that might not seem like a big number to stock investors, that is a pretty big number for bond investors. If you follow the news, you probably heard that the federal reserve has increased its base lending rate a few weeks ago which affects all interest rates. Most economists as well as the treasury itself have said they plan to increase interest rates several more times over the next 12-18 months. This means we are leaving the favorable bond environment and entering (have entered) an unfavorable environment for bonds.
One way to combat rising interest rates in a bond portfolio is to buy bonds with a short maturity. This allows an investor to take advantage of the rising interest rates, because their bond will be renewed more frequently so it can be reinvested into a higher interest bond. For example, if you bought a 10-year bond last year you might be earning 1.5%, while a 10-year bond issued today would be 2.0%. Ultimately, you do not want to be stuck holding a long-term bond while interest rates are rising.
Finally, conservative investors should take a page from the stock investors’ playbook…patience. According to information provided by JPMorgan, there have been six rate increase cycles since 1980. On average, those cycles have consisted of nine rate increases over eighteen months. As the federal reserve has already commented and history suggests, we are at the beginning of this rate hike cycle and not the end. Therefore, we do expect volatility in the bond market to continue.
So, while bond market volatility may feel a little like shooting a basketball left-handed for us “righties,” just know we will be there to coach you through this unusual time.