SoaringInflation& The Problem with Bonds

Finding Portfolio Safety in a Rising Rate Environment

With inflation hitting 8.5%, the U.S. economy is entering a new reality of tight monetary policy.  The Federal Reserve Board has signaled that in addition to prescribed rate increases, they will be aggressively reducing their balance sheet.  This dual approach aims to increase interest rates across the yield curve to reign in the 40-year high inflation. 

Of course, rising rates mean bonds prices are falling.  While the past 40 years have been great for bonds, this paradigm shift could be ushering in a new era of bond underperformance. In the 1st quarter of 2022, the US Aggregate Bond Index was down more than the S&P 500 by nearly 1%.  It is very rare for bonds to lose more than stocks.  This creates a direct impact to stock and bond portfolios with increased losses registered on account statements.

The failure of bonds to provide adequate diversification to equities, while also causing a drag on returns, is why we use portfolio strategies that offer an alternative risk management strategy to dampen volatility.  We use tactical ETF strategies, like our TPSR, that seek to capture equity market gains without the drag of long-term bond exposure.

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Quantitive Easing

The Federal Reserve Bank added $4.5 Trillion to its balance sheet since the Covid-19 economic shutdowns. The $9 Trillion in current holdings is the result of the asset buying programs dubbed quantitative easing (QE). The mechanics of QE are relatively straightforward.  The Fed buys bonds (generally Treasuries and Mortgages) which increases the demand on the bonds available for sale in the market and thus increases liquidity in the financial system.  With higher demand, bond prices increase and yields decrease.  QE has been successful in reducing yields on the longer end of the yield curve (10-Yr Treasuries) while rate cuts have reduced yields on the short end.

https://www.marketwatch.com/story/what-happens-to-money-when-the-fed-starts-shrinking-its-balance-sheet-11647433132

Unwinding QE

Reducing the balance sheet, also called quantitative tightening (QT), operates in reverse. Beginning in May, the Fed plans to start allowing $95 Billion per month in bonds to mature or “run off” without replacing them.  In theory, quantitative tightening will increase rates on the longer end of the curve as demand is decreased and there is an increased supply of bonds available for investors to purchase.  Rising rates result in falling bonds prices.

QT + Rate Hikes = Bond Problems

Over the past 40 years, bonds have had a strong bull market.  In 1981, corporate Aaa bonds reached their 100-year peak at 15.5%.  They have fallen ever since and rest today near 100-year lows.  As interest rates decreased over these years, bond prices continued to climb.  

However, it wasn’t always this rosy. During the rising-rate cycles that preceded 1981, Aaa corporate bonds had drawdowns that could be severe and last multiple years.

Months of Rate Increases

Rate Increase

Approximate Drawdown

Drawdown Years

48 Months

7.6%

-25%

1977-1985 (5 Years)

87 Months

4.3%

-24%

1965-1972 (6.5 Years)

69 Months

1.8%

-15%

1954-1963 (8.66 Years)

7 Months

2.2%

-13%

1987-1988 (1.5 Years)

SOURCE: CME Group - https://www.cmegroup.com/education/files/when-bonds-fall-how-risky-are-bonds-if-interest-rates-rise.pdf

An extra word of caution about rising rate environments; when the starting rates are very low, bondholders are subject to a higher amount of risk.  As rates rise, bonds experience capital losses.  Coupon payments generally help buffer those losses, but when starting at low interest rates the amount of buffer is significantly reduced, e.g., a bond with 5% interest can withstand a 2% interest rate hike better than a bond currently yielding only 2%.

Inflation

Additionally, high inflation doesn’t just make your coffee or gas more expensive.  It also shows up in your portfolio.  When you view the returns from the 1970s, a notoriously high inflation period, you might think that a 60/40 portfolio performed well.  That is until you adjust your returns for inflation using real instead of nominal returns.  

A portfolio that looks like it returned 50% in nominal terms would have actually lost almost 30% in real terms.

Since early 2020, real yields on longer term Treasuries have been negative.  This means that your purchasing power is eroding faster than your investment is returning money to you.  As inflation continues to outpace rates, you can count on this trend continuing.

Maintaining Performance in the Coming Years

Many major financial institutions recognized the impending tight monetary policy and economic slowdown when they made their 2022 Capital Market Assumptions.  The surprising figures below could be an indication that your portfolios will need a new approach through the next decade.  For context, the S&P 500 has averaged 16.34% since 2009.

Capital Market Assumptions by Institution - Forward-looking 10 Year Average Return

Institution

U.S. Equities

U.S. Aggregate Bonds

Vanguard¹

2.3%-4.3%

1.4%-2.4%

Blackrock²

6.7%

1.6%

BNY Mellon³

5.9%

1.2%

JP Morgan⁴

4.1%

2.8%

Research Affiliates⁵

4.3%

2.1%

Invesco⁶

7.0%

1.9%

Average

5.21%

1.92%

If these projections are remotely correct, helping clients reach their goals with a 60/40 portfolio will become significantly harder if not impossible.  Couple these low returns with a high inflation rate, and you could be looking at a devastating investment road ahead for most investors. 

Again, this is why we suggest that all clients add our tactical ETF strategies to their portfolios.  Our tactical strategies allocate capital to equity markets when we detect rising markets.  When markets sell off, our risk management measures activate giving us the flexibility to shift quickly into defensive holdings.  Our primary goal is to minimize material losses in portfolios.  Compared to common strategic allocations, we have a low correlation to the S&P 500, lower annualized volatility, lower value at risk, and lower drawdowns. We use large, highly liquid ETFs to minimize costs, move quickly when needed, and make sure we are not capacity constrained.

We want to make sure they are constantly positioned correctly for the future. Our evidence suggests that using TPSR should enhance the risk-return profile of a portfolio, especially with the grim outlook for a traditional 60/40 portfolio over the next decade.

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Schedule a call with our experts

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If you think TSPR or any of our tactical ETF strategies could be beneficial for your clients, we would love to connect.

TPSR is a low-fee and tactical ETF strategy that uses a rules-based investment approach to either be offensive or defensive depending on market conditions.  This strategy has more than five-years of audited track record and has produced strong returns with proven risk management measures by adjusting to changing markets.

¹ Market perspectives: December 2021 (vanguard.com)
² Capital Market Assumptions | BlackRock
³ Our 2022 Capital Market Assumptions | BNY Mellon Wealth Management
⁴ Long-Term Capital Market Assumptions | J.P. Morgan Asset Management (jpmorgan.com)
⁵  Asset Allocation Interactive (researchaffiliates.com)
⁶  invesco-capital-market-assumption-2022-usd.pdf

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