Physicians' Guide to Wealth

A guide for anyone pursuing financial independence

Q
Bond Busting Market

Mar 17, 2021

Investors were rewarded last year by ignoring all the negative news and holding onto their stock portfolio. The S&P 500 rallied 4.8% to February 19, then dropped 34%, and since rallied 53% through Monday for a period return of 22.85%. It was quite a ride that so far has benefited investors.

Another wild and less reported ride has started that remains to be seen how it works out for investors. I am referring to the less sexy world of bond funds. Having attended investment conferences since the 1980’s, the best food and presentations were by far by the stock mutual fund companies, while across the hall, the bond seminars were a snooze fest. However, that may be changing. On August 4, 2020, the 10 Year Treasury yield bottomed at 0.52% and had since rallied a whopping 211%.

Bond prices move inverse to yield, and for the past 20 years, yields have mostly trended down to the ultralow yields seen last year, pushing up bond values. The low-interest rates have impacted all rate-sensitive instruments and most notably the 30-year fixed-rate mortgage. If you had the opportunity to refinance or buy a home late last year, you most likely secured a mortgage rate below 3%. One client told me they locked in a 30-year rate on their mortgage at 2.1%.

As the 10 Year Treasury yields were skyrocketing these past several months, the values of bond funds steadily declined. As an example, since August 4, 2020, the IShares US Aggregate Bond ETF and SPAB Aggregate Bond ETF have declined 4.78% and 5.0%, respectfully. Considering the significant change in the 10 Year Treasury yield, this seems quite mild.

Investment-grade bonds are a core holding for most institutional and mutual fund portfolios, and despite declining values, it’s a challenge for institutional investors to materially reduce their allocations to bonds. This may explain why the bond market has not been as severely impacted. However, should interest rates continue to rally, then managers may have to start rebalancing out of core investment bonds to income instruments that increase with interest rates that include options, futures, treasury inflation-protected bonds, preferred stocks, and floating-rate bonds. Not surprisingly, these types of investments have significantly underperformed core bond funds for the past 20 years. However, since August 4, most of these funds have either held their values or experienced slight increases. As an example, the IShares Floating Rate Bond ETF has a 0.3% gain since August 4 vs. losses experienced by the above-mentioned bond funds (as mentioned, bond funds are not sexy).

Owning core bonds or bond funds during a rising interest rate cycle is like death with a thousand slices. During the 1970’s the prime lending rate increased from 2% and peaked at 21.5% on December 9, 1980. Bondholders saw their values decline steadily over this period. Less know the aspect of individual bonds is unlike stocks, the daily pricing of bonds are not readily available and typically accurately reported on websites or account statements. The actual price of a bond is determined at the time of sale. During the 1970’s many bondholders didn’t pay attention to actual bond values as they received the same fixed dividend payments each month, and their statements reported the bond maturity values. However, while the dividend payment is fixed, the bond price can fluctuate. When interest rates increase 1000% over a decade, the slow decline of the bond market was devasting. Bondholders during that era that wanted to sell their bonds prior to maturity were required to call their broker, and many were shocked at the significant declines.

With the prime lending rate back down and the federal government is passing multi-trillion dollar stimulus plans, it seems reasonable to assume that both interest and inflation rates may begin a steady rise. The triple punch to conservative investors may be the potential of rising tax rates that lower their net return. Monday, the Wall Street Journal reported that state and federal politicians are debating on how to cover their significant deficits. Since state and federal government's primary source of revenue are taxes, it doesn’t take a rocket scientist to figure out what may be announced in the near future on tax rates.

What Does This Mean to Me?
We maintain our favorable view on the US stock market and economy. Governors and mayors are slowly reopening their territories by relaxing health policies. Unfortunately, the federal government has not made any changes, and many businesses and all federal agencies must abide by the stricter health policies. Nonetheless, there is a distinct increase in business activity. The airports are noticeably busier as airlines are now booking the middle seats. Stocks of the major airlines have rallied even though oil prices have increased. If the US does not experience a significant increase in Covid infections and mortality rate, the economic recovery may pick up serious steam going into the second quarter should the CDC and federal government relax their policies. Institutional investors must think so as they have been adding formerly hard-hit industries to their portfolios that include airlines, hospitality, retail, and dine-in restaurants.

Give us a call or send an email if you have any questions or comments about this UPdate or your accounts. We welcome the opportunity to be of service to you.

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