Can Bonds Bounce Back?

Posted by lplresearch

Tuesday, March 22, 2022

Core fixed income returns are off to one of the worst starts to a year ever. With fixed income markets quickly repricing the prospects of accelerated Fed rate hikes this year, yields across the U.S. Treasury curve have moved higher, putting downward pressure on bond prices across most fixed income sectors. However, one of the positive characteristics of many fixed income investments is that we have a fairly good idea what to expect out of prospective fixed income returns and that is starting yields. Absent defaults, starting yields represent the best expectation for future returns regardless of what interest rates do in the interim. So, as seen on the LPL Chart of the day, after broad based selloffs, bonds have historically bounced back because starting yields, and thus future returns, have become more attractive to investors.

“It has certainly been a rough start to the year for core fixed income investors,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “But higher yields mean there is now an opportunity to invest at better valuations, which may mean future returns for bonds have improved.”

View enlarged chart.

An important point about the negative returns we’re seeing this year is that yields are moving higher because of the expectations of higher short-term interest rates and not an increase in credit risk. This is a huge distinction because higher credit/default risks could represent permanent impairments of capital. That is, if you buy and hold a fixed income investment, the short-term volatility you experience due to changing interest rate expectations is just volatility. It has very little bearing on the actual total return if held to maturity (or if held to the average maturity of a portfolio of bonds).

Moreover, if you consider the historical returns of the Bloomberg Aggregate Bond Index, the overwhelming majority of returns came from coupon income and not price returns (which is generally the opposite of equity investments). For example, over the last five years the index returned 12.52%, on a cumulative basis, of which price volatility only detracted by -0.75% over the entire 5 years (which includes this year as well). Coupon and principal payments are much more important than price volatility.

With yields moving higher recently in most fixed income markets, future returns for fixed income investors have likely improved. We’re seeing increasing investment opportunities in a number of shorter maturity securities (since yields on shorter maturity securities have moved up the most) such as short maturity investment grade corporates and Treasury securities and lower rated corporate credit. While there’s no guarantee that yields can’t go higher, at current levels, which are above pre-COVID levels in most markets, valuations for many fixed income assets are starting to look interesting again.


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