Bond Math 101: Higher Yields = Lower Prices
Not since 1980 has the quarterly return for investment grade bonds been lower than the -6.1% recorded this past quarter. Back then, inflation topped 14.4% before declining to under 3% within three years. Today, bond investors find themselves in the upward swing portion of the inflation cycle watching their real return discounted further by rising inflation driven by new supply shocks and geopolitical events. Reacting, bond investors asked for more future income in the form of higher yields which is accompanied by lower prices.
Federal Reserve – Catching Up with Consensus
Trying to avoid the experiences of past inflation spirals, the Federal Reserve (Fed) looks to be on a path toward more aggressive policy rate increases to slow economic growth and tamp down long-term inflation expectations. In March, the Fed voted to lift the overnight borrowing rate by 0.25% to 0.50% for the first time since cutting the rate from 1.75% to 0.25% in March 2020. Fed board members have further signaled that more aggressive actions, including rate increases in increments of 0.50%, may be necessary at upcoming meetings along with a quickening pace of quantitative tightening (QT). QT is the process where the Fed shrinks the asset side of its balance sheet by not reinvesting maturing bond holdings and in turn making equal reduction to its reserves or money supply. This QT process will impact longer maturity asset prices, especially agency mortgage bonds, as the Fed reduces its mortgage-backed holdings from over $2.0 trillion or about 30% of total outstanding mortgage market.
Facing rising borrowing costs, corporate borrowers rushed to market numerous new debt offerings as March became the fourth largest monthly new issue month on record. Rising supply and rates provided the backdrop for the -7.7% year-to-date return for the corporate bond sector as well as a fourth consecutive month of declining returns, a trend not seen in two decades. Along with our equity team, we have a positive outlook for corporate balance sheets, so we are favoring the corporate bond sector while simultaneously adjusting our duration based upon risk of further rate increases.
The yield of municipal investment grade bonds is often compared to U.S. Treasury yields to evaluate their relative value. For the last year, this indicator signaled that municipal bond markets were overpriced, as investors plowed unspent savings into tax advantaged holdings. That changed in the first quarter, as this sector saw investor outflows and strong new issue supply that led investors to ask for more yield to take on newly minted bonds. Municipal bonds recorded a -6.2% return as this sector moved from overpriced to fair price relative to other bond sectors.
Finally, as unrealized losses appear on account statements, it’s good to remember why bonds are such a common portfolio component. In an uncertain world, it’s good to know what you are earning from the day you buy, and second, unrealized losses disappear as a bond approaches maturity.
Source: BTC Capital Management, Bloomberg LP, Ibbotson Associates, FactSet, Refinitiv.
The information provided has been obtained from sources deemed reliable, but BTC Capital Management and its affiliates cannot guarantee accuracy. Past performance is not a guarantee of future returns. Performance over periods exceeding 12 months has been annualized.
The information within this document is for information purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. Statements in this report are based on the views of BTC Capital Management and on information available at the time this report was prepared. Rates are subject to change based on market and/or other conditions without notice. This commentary contains no investment recommendations and you should not interpret the statement in this report as investment, tax, legal, and/or financial planning advice. All investments involve risk, including the possible loss of principal. Investments are not FDIC insured and may lose value.