Bond Misery Priced In?

As interest rates rise, bonds have taken it on the chin. Bonds lose value when prevailing rates climb because new bonds then carry higher rates, making existing bonds less attractive. With bonds down anywhere from 4%–11% depending on their duration and type, this is the worst year for fixed income since 1994. Long-term bonds are down 11% (as measured by the TLT, the iShares 20+ Treasury Bond ETF).

Despite my belief that top-rated corporate bonds would hold an edge over government bonds–due to higher yields, good credit quality, and insulation from political wrangling–corporate intermediate-term bonds (as measured by the VCIT, the Vanguard Intermediate Term ETF) are down 6.82% year-to-date while equivalent-duration Treasury bonds (VGIT) are down 5.70%. There’s no guarantee, but I would expect corporate bonds to do comparatively better going forward. Their yield is now much higher: at 3.52% vs. 2.24%. Full disclaimer: James Berman owns the VCIT in his own accounts and in those of his clients.

You hear financial pundits claim that if you own bonds until maturity you lose nothing, because so long as the bonds don’t default, you collect the par value when they’re paid off. But this is not correct: it ignores the significant opportunity cost of sitting in a bond for years while newly issued bonds outpace your yield.

There’s some good news: bond prices anticipate Fed rate hikes long before they actually occur. So it’s likely that much of the damage has already been done. In 1995, for example, bonds rose 23% after losing 8% the prior year. In addition, yields are finally competitive. At 3.52%, corporate bonds now have a yield above and beyond the long-term inflation rate. That’s a vast difference for investors and retirees.

The current inflation numbers, as high as 8%, could still surge for a while. But this Federal Reserve is not the Fed of Arthur Burns in the 1970s. Fed Chair Jerome Powell and his governors have been very clear about fighting inflation, even suggesting hikes of 50 basis points could be coming. Those betting on persistent, structural, decade-long inflation like the bad old ‘70s are likely to be wrong.