If you’ve been checking in on investment performance lately, then you’ll know that 2022 has been a difficult year so far. One of the key reasons for this struggle has been the double whammy we’ve seen both the bond and stock market take – a very rare occurrence in the world of investing.
For those who have invested in the bond market for years, this change feels like the end of an era. The growth of bonds has been in a boom that’s lasted at least three decades, so for many of us, the warning signs were everywhere.
What’s bringing bond prices down?
We’re currently seeing inflation hit the highest rates that have been seen in a generation.
The way bonds work is that you pay a price to receive future payments from the seller of the bond. When you buy a bond, you are essentially lending money or buying debt, so the seller of the bond has to pay you interest, in the form of periodic coupon payments as well as the full value of the loan when the bond matures (which means reaching the end of the time period you agreed on when you purchased that bond).
This is important to know because when interest rates increase, bond yields also increase. This might sound like good news but due to the way bonds work when the yields increase, the purchase price of bonds falls. This is because the future value of the coupon (or interest payments) and the final value (or loan amount) is worth less than it was when you initially bought it, as when interest rates are positive, investors could simply put their money in the bank and earn the interest for that same period.
This is exactly what we have experienced in the bond markets during the start of 2022, with higher interest rates driving higher yields and causing lower bond prices. This change in fortune has seen many investors start to pull out of bonds – for the US bond mutual funds, this adds up to a combined value of $100bn, according to the Investment Company Institute. If this trend continues, it would be the first year that we’ve seen more money being taken out bonds than invested in them since 2013.
“The long bull market run in bonds has come to an end,” says Scott Minerd, global chief investment officer at Guggenheim Partners, who helps oversee $325bn in assets.’
Are bonds still safe?
Bonds have always been considered a ‘safe’ investment, with their price generally increasing when the stock market becomes more volatile. This counterbalancing normally helps to reduce the losses experienced in a diversified portfolio, however, with bonds being impacted as well, it begs the question if bonds are still a safe investment.
In terms of a ‘safe investment’, bonds have traditionally been stable, but they do carry some risks.
- Interest rate risk – value might fall if newer bonds have more attractive rates
- Reinvestment risk - the cash flow goes into new bonds with lower yields
- Call risk - if the bond’s term is cut short by the issuer (may happen if interest rates fall)
- Default risk – may happen if the issuer is unable to meet its financial obligations
- Inflation risk - the possibility that inflation erodes the value of a fixed-price bond
As a bond is a form of loan, and the issuer of that loan promises to pay you back interest, there are still external factors that mean your money is still at risk when investing in bonds.
Is this normal?
The steepness of this cycle has been highly unusual.
Usually, we would see a gradual lifting of rates in response to demand-driven inflation. This would normally be a good signal for growth, and therefore stocks would do quite well, masking any negative performance from bonds. However, once interest rates started to bite on growth, stocks would then begin to fade, and central banks would be approaching the peak of the rate hiking cycle. A recession may come into play as the monetary tools used by central banks often have a significant lag.
At this point yields and rates would have to reverse and there may be a flight to safety which would be good for bonds. Bonds would then benefit from central banks lowering rates, and this positive performance could balance out some of the decline seen in stocks.
The surge in inflation we’ve seen in 2022 has put central banks under a lot of pressure to try and keep prices steady. To do this, most central banks follow an inflation targeting regime which increases interest rates. And, as we discussed earlier - when interest rates rise, bond prices fall.
As the rise of inflation has been very steep, the interest rate hikes have had to match that – this has created a sharp drop in the price of bonds. The severity and speed of this has been unprecedented.
While we don’t have a crystal ball and aren’t able to see into the future, we do believe that the current level of yields means that there could be room for yields/rates to fall again, which in turn, would increase the price of bonds – a potential positive for bond investors or those with a diversified investment portfolio.
That would be how a typical bond cycle works, with bonds losing value as rates increase in response to inflation, and then gaining value as rates decrease to restore economic growth lost due to rate rises. This time around it’s just been much steeper and sharper than we’re used to.
Wealthify does not offer advice, if you’re not sure whether investing is right for you, then please speak to a financial adviser.
With investing your capital is at risk, so the value of your investments can go down as well as up, which means you could get back less than you initially invested.
Please remember that past performance is not a reliable indicator of your future results.