There are axioms that we accept in life as basic truths. Time flies when you’re having fun. Missing car keys will always be found in the last place you look. Bonds are safer than stocks.
That last one has been well-ingrained in just about every investor — backed by a century of irrefutable evidence. A bad year in the bond markets might mean a 5% or 6% decline. The S&P 500 can wake up in a foul mood and do that before breakfast.
Of course, the reverse is also true. That’s the tradeoff.
Stock represents ownership in a business, so even the smallest perceived failures and successes can have an impact on daily prices. Bonds are simple IOU certificates. Unless there is a real threat to the company’s credit rating (and ability to fully repay principal and interest), bondholders don’t get too worked up about every little data point.
They aren’t nearly as excitable or jumpy. The same weak earnings report that triggers a noisy stock exodus might not even stir up a ripple in the bond market. I think of bonds as ponderous, slow-moving elephants surrounded by wild, high-beta hyenas.
Take Disney (NYSE: DIS). Shares of the media and theme park empire have whipsawed and tumbled more than 20% since mid-August, wiping out $45 billion in market capitalization.
Meanwhile, creditors have yawned. A 6.2% note maturing in 2034 backed by the full faith and credit of Mickey & Co is trading near the same price today as it did then.
Stodgy? Perhaps. But when storm clouds gather, the return of your money matters more than the return on your money. Even when skies are fair, these reliable, interest-bearing instruments still play an important role in any well-rounded portfolio, particularly those where capital preservation is a priority.
A Historic Bad Year Is Setting The Table For A Rebound
Let’s not forget bonds are also coveted for their low (and often negative) correlation with equities. That’s a fancy way of saying that when one group falls, the other tends to rise. So when stocks tank, bonds can help cushion the jarring impact.
At least, that’s what they teach in Finance 101. And normally, it is true. But as we discussed in last month’s issue, 2022 was anything but normal. A perfect storm barreled into this usually placid financial enclave, bringing extreme conditions that few have seen in their lifetimes – at least anyone born after 1926.
To combat inflation, the Fed aggressively raised interest rates seven times. And as we all know, interest rates and bond prices move in opposite directions. In previous rate-tightening periods, capital losses were at least partially offset by coupon income (just as a 5% dividend can soften a 10% decline in a stock). But with the Fed funds rate locked near zero, we didn’t have that luxury this time.
As the Wall Street Journal reports, taxable investment-grade bonds (as measured by the Bloomberg U.S. Aggregate Bond Index) suffered a historic decline of 13% last year.
Source: Wall Street Journal
Last year’s 13% drop doesn’t sound that bad. But in a world where a 3% dip is practically considered bear market territory, this is a 100-year drought. The only comparable slump in recent memory was in the early 1980s when the Fed waged a similar war against inflation. 2022 for bondholders is every bit as painful as 2008 was for stockholders (when the S&P 500 cratered 36%).
For the record, stocks rallied sharply that next year. In much the same way, bond market selloffs also give way to recovery – only the rebounds have been swifter. It took just 9 months for bonds to reach a new high following a beatdown in 2016, 5 months in 2003, and just 2 months in 1984.
Preferred stocks (which behave like bonds) also felt the sting, tumbling about 18%. And long-term Treasury bonds, the most sensitive to rate fluctuations, lost a staggering 24%.
And that’s just raw index performance. Some bond-centric closed-end funds were walloped even harder due to their use of leverage. Far from being a safe harbor, the fixed-income seas were volatile and dangerous last year. Investors reacted by withdrawing $237 billion in bond fund assets, the largest net outflow on record.
Action To Take
Should we challenge all of our long-standing assumptions and rethink the relationship between stocks and bonds? Not really. I chalk up this freak occurrence to a common bubble burst clashing with a black swan event (namely the Covid pandemic, which stoked inflation and set events in motion).
I wouldn’t tell conservative investors to start abandoning bonds. Quite the opposite — now might be an opportune time to load up.
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