This article was co-written by Nate DeMeo.
Last week’s Federal Reserve announcement regarding the tapering of bond purchases that started this month — and is anticipated to fully wind down by June 2022 — was received with little fanfare by stock and bond markets. It is likely that, since the expectation for tapering was widely telegraphed, it was already “priced in” to market expectations.
What exactly does “tapering” mean?
Since March 2020, the Federal Reserve has been purchasing $120 billion of treasury and agency backed mortgage bonds monthly. This was one part of the massive and unprecedented liquidity the Federal Reserve provided financial markets in response to COVID-19. While the Federal Reserve has since cut back on many of the emergency relief measures, the monthly $120 billion purchases of treasuries had continued. The beginning of tapering down these purchases is an important milestone in signaling that the economy is on solid enough footing for the central bank to take off the training wheels.
What comes next?
The next question for many investors is when the Federal Reserve might begin to raise interest rates. Chairman Jerome Powell has been clear that bond purchase tapering and rate increases are two separate tools. With that said, many within the Federal Reserve board expect to begin rate hikes as early as the middle of 2022. This also aligns with futures market expectations for rate increases.
When interest rates go up, bond prices go down. Understanding this axiom and seeing the expectation of future federal funds rate increases — on top of the decline in value we have already seen in some of the bonds within a well-diversified portfolio this year – may be causing concern about the role of bonds within a portfolio going forward.
Why do you need bonds?
It’s important to remember that bonds generally don’t stand alone in a well-diversified portfolio. Instead, bonds work together with stocks to round-out an investor’s overall allocation. While stocks have provided higher historical returns and can serve as the growth component of portfolios, they are also more volatile, particularly over short- to intermediate-time periods. In contrast, bonds have experienced more modest historical returns but have also offered less volatility to investors. That certainly doesn’t mean bonds haven’t experienced periods of time when returns were negative, but, compared to stocks, those periods have historically been much less frequent.
For example, over the last 20 years the MSCI World Stock index (representing all developed market countries) has experienced 6 years when returns were negative, compared with just 1 year for the Bloomberg US Aggregate bond index.1 Looking at the chart below we can see the maximum drawdown over the last 20 years for those two indices as well. During that time the MSCI World Stock index experienced an average drawdown of -10.99%, versus -1.96% for the Bloomberg US Aggregate index.2
Market drawdowns of stocks vs bonds
November 2001 to October 2021
Source: Morningstar Direct
In 2008, when the MSCI World Stock Index experienced its sharpest drawdown of over 54%, the Bloomberg US Aggregate bond index was down just 3.8%. Bonds have also tended to perform differently to stocks. For those concerned about a potential pull-back after the recent strong performance of stock returns, bonds can provide a much-needed source of stability during periods of market decline.
If the Federal Reserve raises rates, aren’t my bonds destined to have a negative return?
Not necessarily. The Federal Reserve sets the Federal Funds Rate, which is the interest rate at which banks trade federal funds (balances held at Federal Reserve Banks) with each other overnight. If the Federal Reserve raises rates, that tends to impact bonds with shorter maturities.
For bonds with longer maturities — like intermediate-term bonds — it is the market supply and demand that determines the bonds’ interest rates and prices. You can see from the chart below how different segments of the bond market have performed during various Federal Reserve rate hiking periods. As we can see rate hikes do not automatically spell doom and gloom for fixed income investments.
Performance of bond market segments through rate hiking cycles
This does not mean that rates can’t go up (and bond prices go down) in the intermediate segments of the curve if the supply and demand dynamics change for the bond segments. They can and they have for investment grade taxable bonds as witnessed this year.
But it is important to remember that while bond prices initially go down when the prevailing interest rates go up, over the longer-term, rising rates benefit investors.
Why? Because when rates go up, bond investors can re-invest cash flows from coupon payments and bond maturities at those higher rates. This tends to mean better longer-term returns since bonds derive a larger portion of their return from those underlying coupon payments relative to some other asset classes. So, the short-term pain can mean longer-term gain.
Wrapping it all up
This year, while equity markets have soared, high-quality bonds have experienced some negative returns, but that doesn’t mean it is time to dump those bonds. Instead, we recommend re-affirming the purpose of those bonds in the portfolio and – when appropriate – utilizing active managers within the fixed income space to navigate the changing landscape.
Bond managers can adjust a bond portfolio to have less sensitivity to rising interest rates, as measured by a portfolio’s duration, and allocate to various segments of the fixed income market that are likely to benefit from a given market environment.
Holding a well-diversified portfolio with exposure to different segments of the financial markets means a less bumpy ride over time, allowing us to confront the “unknown unknowns” that surface in the markets. It also means hanging on to some segments of the market that aren’t the top performers each year. This is never an easy task even for stead-fast investors, but one that is been shown to provide a smoother journey over time.