Our Thoughts On The Bond Market
As much as our daily discussion focuses on the stock market, the bond market has been almost as interesting and important so far year to date. We always talk about the S&P and how the biggest stocks are doing, but gathering insights and having a plan within the bond market has been just as critical. A lot has happened since last year and I wanted to point out what we’re watching and doing on the fixed income and bond side of the portfolio.
Much like the stock market, it’s difficult to time and predict what the bond and interest rate market will do. We have some direction from the Fed, but lately that only affects the very short end of the yield curve. When it comes to longer-dated treasuries or bonds, there are many more factors at play, mainly economic and market variables. We’ve had a lot of client questions come up lately as to why we’re not just holding very short-term treasuries yielding over 5%. In some cases, this is a GREAT strategy. However, the 5% won’t last long, and it may not be the best long-term strategy. We need to balance taking advantage of great short-term rates with the risks we deal with in the bond market, which look a bit different from the stock market.
The 3 Main Bond Risks We Evaluate
1) Interest Rate Risk – This is essentially how the price of bonds can and will move. Before 2022, the preceding 35 years we had been in a declining interest rate environment, and a gradual one at that. This meant, for the most part, the value of bonds would increase (bond price and interest rates are inversely related). Last year we saw a rising interest rate environment with a rapid pace of increases. This created massive volatility in the market sending the Barclays Aggregate bond index down close to 18%, something we hadn’t seen before. This was one of the reasons we moved to alternative asset classes beginning in the latter half of 2021. A rising interest rate environment is bad for the price of bonds. The good news is that it can act as a positive for longer-term investors looking for yield, which brings us to risk #2.
2) Reinvestment Risk – This is the risk that when a bond matures, the interest rate you will reinvest at will be lower than it is today. This presents the trouble with today’s yield curve and interest rate environment. Yes, you can invest in treasuries maturing in 6 months at 5.4%, but where does that leave you when you receive your principal back and reinvest in six months? If market expectations are right and yields come down, you won’t find similarly high rates. This is why it may make sense to take a lower interest rate that you can lock in for a longer period. Yes, you are giving up some current yield, but the expectation is you will capture a higher rate of return in the long run.
3) Credit Risk – this is the risk of the creditworthiness of the bond issuer. Typically, with Treasuries the creditworthiness is strong, but in the last few weeks this did come into question. Fortunately, the House and Senate were able to come to terms last week and the debt ceiling crisis was averted. The U.S. government historically is the most credit worthy borrower there is, but it also keeps yields down. The riskier the borrower (think junk bonds), the higher the rate the lender demands. We typically don’t reach for too much risk or junk in the fixed income side of our allocation since we view it as a ballast to our equity and stock exposure.
Given all these risks, how should we be approaching the fixed income market? For one, we’ve seen rates continue to rise since the Silicon Valley Bank collapse in early March. Because of this, we are seeing some opportunities in short to intermediate-term bonds which we may take advantage of. Yields for treasuries dated 1-3 years look attractive compared to where they’ve been, so we’re keeping a close eye on them. The 5-10 year market hasn’t recovered as much yet, but we continue to watch and see if opportunities arise, which they may, given how strong the latest economic numbers have been.
We’ve continued to hold a large portion in ultra-short duration bonds giving us over 5% yield. This has worked out well so far, but isn’t a forever strategy because eventually rates will come down. We started entering the bond market towards the end of last year, and more so earlier this year. We will continue to try and capture the best rates we can. Bonds are a math game, and typically the point you enter is the expected long-term rate of return you should expect. It’s no different than stocks in two ways – 1) you can’t try to time the market and 2) you must have a long-term mindset to take advantage of that math and not panic when rates change.
Treasury ladders, whether done individually or using ETF’s, continue to be a good risk management strategy. If you have substantial cash on the sidelines, not earning much at your local bank or in your savings accounts – we can help. We’re working with clients all the time figuring out the best ways to capture yield while we can. If you are unsure of what to do with some of your cash holdings, please don’t hesitate to reach out to an advisor for some guidance as to the best approach.
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