Posted by Lawrence Gillum, CFA, Fixed Income Strategist
Tuesday, October 18, 2022
The start of the 2000s was a trying time for equity investors. After the dot-com bubble burst that saw equity prices fall nearly 50% from peak to trough, it took the better part of the decade to recover those losses. It took patience, but the equity market did eventually recover. Now, the core bond index (as defined by the Bloomberg Aggregate Bond index) is seeing losses unlike any year since inception of the index. Core bonds are down nearly 16% this year and this year’s losses have wiped out five years of gains for the index. So, with the decade of low interest rates seemingly coming to an end, bond market investors may be in a similar position. However, within the fixed income markets, because bonds are not only financial instruments, but also financial obligations that pay coupons and principal repayments at par at maturity, the potential for recovery is a bit more certain than in the equity markets that relies primarily on price appreciation. So how long will it take to recover this year’s losses?
The table below provides some expectations for various fixed income markets under different interest rate scenarios. If interest rates don’t change at all, the best expectation for performance over the next year would be the index’s starting yield (dark blue highlighted section). However, if interest rates decline by 0.5%, the Bloomberg Aggregate Bond index could return over 9% over the next 12 months. Moreover, if interest rates move back into the low 3’s, the core bond index could return around 12% over the next year. Also, importantly, given where starting yields are, if interest rates increase by another 1% from current levels, only the Bloomberg Treasury index is expected to generate further negative returns. Given the move higher in yields we have already experienced this year, we think the risk/reward for owning core bonds has improved.
While it may be tempting to hide out in cash or other short-term financial instruments, we think the potential for price appreciation within core fixed income could help offset the earlier losses faster than collecting income alone. There is no doubt that this year has been a challenging year for core bond investors but we do think the worst is behind us. Like the equity markets at the beginning of the 2000s, it will take patience to fully recover this year’s losses, but we think the best way to do that is to stay invested lest you may miss out on the recovery in the fixed income markets that will eventually occur.
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