20 JULY 2022


By Raul Elizalde

This article also appeared on

Inflation keeps rising, and it’s now in the upper range of U.S. recorded history. By some measures it has already reached a record high. It all happened with lightning speed.

The world flirted with deflation in the 2010s, and the Covid-19 pandemic that capped the decade made the risk worse. It scared central banks everywhere, because they don’t have good tools to fight deflation which, once entrenched, can destroy economic growth. So they embarked on a long-term, seemingly fruitless effort to push up inflation with low rates and liquidity injections to keep prices from entering a downward spiral.

Careful what you wish for. For a variety of reasons, by no means all of the central banks’ doing, a tipping point was reached. Inflation not only came back, but it made an explosive entrance in late 2021. Turning monetary policy around from more than a decade of fighting deflation to fighting the opposite enemy in a matter of months is not easy, regardless of what critics of the Fed might say.

So here we are, with inflation soaring and the Fed pushing up interest rates to keep it from getting out of control. This brings down the price of bonds, and a recent paper by the New York Fed describes the current bond selloff as the fastest, longest and deepest in 40 years.

source: Path Financial LLC, Federal Reserve Bank of St. Louis
Part of the reason why the bond slump has been so brutal has to do with the way bonds respond to rate changes. Low interest rates in the past few years spawned bonds with low coupons, which are more sensitive to rate increases than high-coupon bonds. Also, a bond’s price falls less in percentage terms when its rate goes from 6% to 8% (as in 1993, for example) than when it goes from 1% to 3% (as now). When rates are low, the same increase in yield causes a larger decrease in price.

Why does all this matter to investors? Because for many decades they were told to diversify their portfolios by altering the proportions of bonds and stocks they hold, but in the last year or so this has done nothing to improve the performance of their portfolios. There are reasons to believe that this is not just a temporary aberration, but instead a new state of affairs that investors need to examine.

Mixing stocks and bonds to create a solid portfolio is not intrinsically flawed except when “bonds” get confused with “bond funds.” The latter can be shown to be great investments when looking at 40 years of market history, but the problem is that those four decades sport ever-declining interest rates, down from the peak of 1982. In that environment, bonds do well since their prices rise when interest rates fall. As we discussed in a previous post, bond funds benefit particularly well from this due to the way they are constructed.

The diversification sweet spot that a 60/40 portfolio supposedly provides draws heavily from this four-decade rally in interest rates. Even today, 401(k) plans have been simplified for investors (some would say dumbed down) with “target-date funds” - portfolios that increase the proportion of bonds as the account owner gets closer to retirement, under the premise that bonds can preserve capital better than stocks.

But everything comes to an end, eventually. The Fed is pushing up rates to cool down the economy, and that rates are still far below inflation suggests that the Fed has a long way to go. The market expects that Fed Funds, currently at 1.75%, could be as high as 3.75% in the first quarter of next year.

All this has seriously blunted the diversification benefits of bond funds. In the last 12 months, the total return of the S&P 500 (that is, including dividends) was -11%, which is the same as the total return of bond aggregate indices, such as the Barclays U.S. Aggregate. For the time being, at least, bond funds do not help.

source: Path Financial LLC, U.S. Dept. of Commerce (Bureau of Economic Advisors)
Bonds can still offer diversification benefits to investors, just not in index form. Bond mutual funds and ETFs, by construction, can be underwater indefinitely, unlike individual bonds which always pay back the principal amount (unless they default).

The New York Fed article concludes by saying that the bond slump is so deep and the outlook so inauspicious that it might take another seven years for the bond selloff to end – that is, for holders of a bond index to recover the losses. While this seems to me a bit too long, the paper was co-written by the head of Capital Market Studies at the NY Fed and a director of the Monetary and Capital Markets Department at the IMF. It deserves serious consideration.

A complaint heard often is that there is nowhere to hide in today’s market, with stocks and bonds in a downtrend and cash losing ground to inflation. One way for investors to get positive returns, is to buy individual bonds and (this is crucial) hold them to maturity. Bonds rated investment grade by at least one agency and maturing in 2023 currently have yields as high as 5%, and they are increasing. This is not only better than cash, but far better than what bond funds will do if interest rates continue to rise.

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