The Coming Moment for Bonds
Disclaimer: I am not a licensed investment advisor. The following is meant to be educational and not a form of specific advice. Consult with a CPA, attorney, financial advisor, and significant other if you have one before making investment decisions. Thoughts below do not represent First National Bank or First National Wealth Management or First National Investment Services.
The Coming Moment for Bonds
2022 was a rough year for investors. While the Dow Jones was down a somewhat modest 8.8%, the more comprehensive S&P 500 was down nearly 20% with the tech-heavy NASDAQ down a whopping 33.1%. If you lost less than 23% in your portfolio last year, you did better than the average retirement saver according to data from Fidelity.
What clobbered many investors last year was not just the stock market drop, but significant losses in bonds as well. Why? How? Aren’t bonds supposed to be safe investments? Well, a lot of people learned the hard way that bonds can and do lose value, as the Bloomberg Aggregate Bond Index, which is generally reflective of the overall bond market, lost 13% in 2022. In fact, this was the first time since 1969 that both the stock market and the bond market dropped by double digits in the same year.
Longtime readers of The Sunday Morning Post may remember I wrote about The Perils of Safe Investments last May, which I will quote again in part today:
More commonly of late, however, bonds have dropped in value…because interest rates are going up. The reason for that is that the price of a bond (i.e. what you could re-sell it for) is inversely related to interest rates. Think of it this way: if you own a bond that pays a 3% yield but then interest rates go up to 4%, not as many people want the 3% bond anymore, so the price of that bond (i.e. what the holder of the bond could re-sell it for) drops. It also works the opposite direction: if you own a bond that pays a 7% yield and interest rates drop to 6%, your 7% bond is comparatively more valuable and the price/value of that bond would likely actually increase...
Bonds become comparatively less valuable as interest rates rise because all new bonds issued are generally going to be issued at a higher interest rate, making the current bonds that were issued at lower rates comparatively less valuable…
To briefly summarize my main points today, “safe” investments are not always safe as in the case of bonds where their values can actually decline both in real terms and relative to inflation.
And that is what happened. Bonds lost value in 2022 because interest rates went up quite significantly, which made bond prices drop. This was especially unfortunate for many investors who included bonds as a conservative hedge in their portfolios thinking that they would not drop in value. Indeed, I do not think many investors even thought bonds could drop in value.
The Mood All Changed
The investment landscape in February 2023, however, is now significantly different than it was in May 2022 when I wrote the words above. And the moment for bonds is coming. Why? Well, for starters, bond yields have increased significantly in the past year. The yield on a 12-month Treasury Bill is currently 5.1%, which is the highest percentage since the year 2000. By comparison, one year ago the yield was just 1.1%. The 10-year Treasury Bill is yielding 3.95%, a yield not seen since 2010. One year ago the 10-year yield was 1.8%. Interestingly enough, the yield currently being lower on the 10-year versus the 12-month suggests that the bond market as a whole projects interest rates to drop in the years ahead. Either way, 5.1% for one year and 3.95% annually for ten years are rates that are going to appeal to a lot of investors.
But here is the kicker that will make investments in bonds particularly attractive in the months ahead. Bond prices (i.e. not yields) are also likely to increase over the next few years. Why? Because interest rates will eventually come down. I do not think we are there yet, but the moment is coming. A particularly poor inflation report this week showing prices that are staying stubbornly high is going to give support to the Fed to keep hiking interest rates this spring, possibly by another 0.50% at least one more time and possibly even more this summer. We may still be 12-18 months out from any meaningful decline in rates. But eventually, the interest rate hikes will be tapped out and rates will eventually start to ease. At that time, bond prices could increase because remember, just as bond prices fall when interest rates rise, bond prices increase when interest rates fall. Investors therefore might earn both a higher yield and an increasing price of their underlying bonds.
Now, a caveat to this is that yields are higher largely because inflation is also higher. So what investors might gain in investment yield they are losing at the grocery store, when they pay their utility bills, when they eat out, or when they go on vacation. But, bond investors potentially being due for both higher yields and increasing prices on the bonds they hold is a great formula for success in these perceived-to-be-safer investments, which will be a welcome turnaround after a dismal 2022.
Ben Sprague lives and works in Bangor, Maine as a Senior V.P./Commercial Lending Officer for Damariscotta-based First National Bank. He previously worked as an investment advisor and graduated from Harvard University in 2006. Ben can be reached at ben.sprague@thefirst.com or bsprague1@gmail.com. Follow Ben on Twitter, Facebook, or Instagram. Opinions and analysis do not represent First National Bank. © Ben Sprague 2023.
Weekly Round-Up
Here are a few things that caught my eye around the internet this week that I thought might interest you too:
Via Bill McBride of Calculated Risk Blog, for the first time since the data has been tracked there are more built-for-rent properties being built than built-for-sale. My guess is that this represents homebuilders trying to capture long-term income from the red-hot rental market over the past few years while sensing a top in the home purchase market. Some homebuilders who got burned in 2008 have been trying to diversify to rentals instead. Read more.
Walmart, largely considered a bellwether for the overall economy, released earnings this week and presented a mixed picture. The month of December was its strongest month of sales in the company’s history and Wednesday’s earnings per share of $1.71 easily beat industry expectations of $1.51 per share. However, cautious guidance for the year ahead spooked investors. Per the Walmart CFO, “The consumer is still very pressured. And if you look at economic indicators, balance sheets are running thinner and savings rates are declining relative to previous periods.” Read more.
After briefly touching 5.99% on February 2nd, the average 30-year fixed mortgage rate was all the way back up to 6.88% by the end of the day Friday. That is a big jump in less than a month and presents headwinds to the real estate market as we turn towards the spring, a time when sales are typically picking up. The chart below via Mortgage News Daily shows the trajectory of mortgage rates over the last year. The traditional 30-year fixed is the dark blue line with the run-up over the past three weeks evident.
Perhaps as a sign of the times, via Rick Palacios Jr. of John Burns Real Estate Consultants, the number of realtors is down for the first time in awhile. Although, to be sure, there are still a lot of realtors out there. With a smaller pie of sales to be split in the months ahead, I expect the number of realtors will continue to drop as there just won’t be enough to go around.
Have a great week, everybody. If you enjoyed or found value in today’s article, please consider sharing with friends and colleagues or on social media.