CLIENT QUESTION OF THE WEEK: After looking at recent performance, I have a lot of questions about my bond returns. How do I start to think about this?
Bond returns in Q1 were some of the worst in decades. Many fixed income funds lost money, which can naturally cause anxiety amongst investors. We broke this anxiety down into specific questions to address the different components of concern.
Why have my fixed income funds lost money?
- The bond market incorporates new information quickly. Broadly, the market has likely adjusted expectations for interest rates and inflation.
- The Effective Federal Funds rate has increased year to date1; buyers and sellers have incorporated that information, as well as their expectations about future changes in interest rates, into prices.
- Typically, higher future inflation and interest rates make current bonds less attractive. This is because most bonds pay a fixed interest rate (or coupon), and if interest rates for newer bonds rise, investors will no longer prefer the lower interest rates provided by older bonds.
- Market participants can then demand a higher yield of existing bonds by driving the price of the bonds down, resulting in negative performance for existing bond holders.
- Don’t focus on getting bogged down in the math. Just remember that when the yield of a bond increases, its price will decrease. This is what we saw in Q1.
Why should I continue to hold fixed income?
- There is good news! Rates are more attractive now, which can be positive for future returns and reinvestment. Moving from a low-rate environment to a high one can be painful, but we’ve seen it benefit investors in the long run.
- Negative performance of fixed income is frustrating, but not unprecedented. Short-term negative returns occur more frequently than you may realize. However, through a longer-term perspective, down periods don’t seem as daunting.
- Over recent decades, we’ve seen positive performance in periods of rising Federal Funds rate. Exhibit 1, which includes the most notable periods of Effective Federal Funds rate increases, illustrates that periods of rising rates do not necessarily result in ongoing negative returns.
- Trying to outguess the market on future rates or inflation often leads to disappointment. Only 11% of active mutual funds (which try to make these bets) that existed 20 years ago outperformed their benchmark over the 20-year period ending 12/31/20202.
What role does Fixed Income play?
- Bonds are continuing to deliver on the job they were hired to do. Fixed Income portfolios can be customized to meet your unique needs. A financial advisor can help select appropriate solutions for investors based on their particular goals and risks.
- Bonds can be used to dampen volatility relative to equity, provide liquidity, generate income, and meet sensitive tax needs.
- Different bonds have different risks and components of return. For example, corporate and municipal bonds offer a credit premium for the probability of the issuer defaulting.
Should I do something about inflation?
- Prices already include expectations for inflation. On average, hundreds of billions of dollars of treasury bonds are traded daily3. Market participants incorporate their expectations around future inflation into their trades. As new information develops, they may reassess their expectations.
- History tells us that equities have done a relatively good job of protecting investors from inflation. Dimensional’s article Will Inflation Hurt Stock Returns? Not Necessarily explores how there is not a reliable connection between periods of high inflation and stock returns.
- For those investors who are sensitive to unexpected inflation, there are options available. One option, Treasury Inflation-Protected Securities (TIPS), are linked to changes in consumer price. An alternative is buying short-duration corporate bonds while using inflation swaps to protect against rising prices. This strategy involves more credit risk but offers higher expected returns and allows greater diversification relative to TIPS.
Is a recession coming?
- At some point…probably, but there’s no reliable way to predict it.
- Dimensional’s paper The Flat-Out Truth shows that an inverted yield curve is not a proven signal to investors that they should make a move.
- The opportunity cost of being out of the market for even a brief time can have a devastating impact on a portfolio.
- Rates are more attractive now. Pain in the short-term doesn’t indicate that fixed income will be down in the long-term.
- Expectations are priced in. Investors don’t need to dedicate time or resources to predicting the Fed’s next move and speculating on impacts.
- Dimensional is making dynamic changes, but you don’t have to. Leveraging a systematic approach to managing fixed income that uses information in market prices is a more reliable way to improve expected returns rather than trying to read the Fed’s tea leaves.