The bond market in the US and other rich countries has long been boringly predictable, with prices by and large going steadily up and volatility far milder than in the more-talked-about stock market. The inflation that set in as economies rebounded from their pandemic collapse changed all that, leading global bond prices to fall by the most in at least three decades. The rout is forcing a rethink of frameworks that have long governed investments in the $100 trillion field.
1. Why is inflation so bad for bonds?
For two reasons. A bond is a contract laying out a series of fixed payments over time. The right to collect those payments is less valuable if inflation is expected to erode their purchasing power. The other reason has to do with the traditional central bank response to inflation: raising interest rates, a step meant to slow down economic activity by making borrowing more expensive. An increase in interest rates has a side effect of reducing the resale value of existing bonds. That’s because when bonds with an interest rate of 3% start landing on the market, traders will pay less for bonds paying 2%. Prices can begin to fall even at the first hint that a central bank might be considering a hike.
2. What’s been happening?
Bond prices hit a peak at the start of 2021, then started to slide when inflation began to surge. That fall accelerated as it became clear later in the year that price increases were not transitory, as the US Federal Reserve at first predicted. Then in early 2022 a number of factors ratcheted inflation fears up even further, including Russia’s invasion of Ukraine, the sanctions imposed by the US and European Union in response, and a new round of pandemic-caused shutdowns in China. In March, the Fed launched what officials said would be a series of significant interest-rate hikes. By June 14, the Bloomberg Global Aggregate Index, a measure of total returns on corporate and government bonds, had fallen 19.7% from its peak.
3. How big a deal is that?
While that might not sound like much in the more volatile stock markets, it was the largest so-called drawdown in bond market records going back to 1990. By one estimate, 2022 looks like the worst year for US bonds since 1842, when the nation was mired in an economic and financial crisis. Interest rates had been on a downward trend from the early 1980s, when the Fed conquered double-digit inflation — meaning that bond prices had been in a seemingly endless bull market since then. That rally had been supercharged more recently by the massive central bank response in 2020 to the pandemic’s economic toll, when the Fed cut rates to near zero.
4. Is inflation the only issue?
No. As the world’s biggest central banks either began or prepared to fight inflation by pulling back on economic stimulus, worries rose that the effort could tip some countries into recession. Investors in bonds have a somewhat different view of downturns than most people. On the one hand, hard times lead to more defaults, which are bad for lenders. On the other, interest rates typically fall in recessions, meaning bond prices often rebound. Closely-watched parts of the US yield curve, often hailed as harbingers of economic downturns, have inverted in recent months.
5. Where did that leave investors?
In an unusually tricky spot. In many portfolios, bonds are valued for steady income streams, for their lack of volatility, and because they can usually be counted on to move in the opposite direction to the stock market. Those last two features haven’t held up recently. An investor who had a 60/40 portfolio, the classic risk-averse strategy named after its share of equities and high-grade debt, saw its value tumble by a fifth this year, as of mid-June. In the short term, traders were having to decide if the low prices were tempting — itself a bet on whether inflation was likely to peak soon. Others were still recommending that investors reduce their bond holdings, expecting that inflation would remain at historically high levels even if a peak was reached. In that case, long-term yields could have further to climb as investors demand greater compensation for lending over a longer period with inflation eating into their returns.
6. What does it mean for borrowers?
Rising interest rates will likely take a toll on economic growth. In the US, the effect of more costly mortgages could be seen in the month after the Fed’s first hike, as sales of new single-family homes fell to their lowest level since pandemic lockdowns began in 2020. And companies, especially those with poor credit ratings, will find it more expensive to raise debt. As the days of easy money supplied by central banks came to an end, the credit-worthiness of borrowers returned to its normal prominence in the bond market.
• Bloomberg stories on the poor performance of corporate bonds as inflation pressures mount; the difficulty facing the Fed in achieving a “soft landing” as it raises rates.
• A 2018 opinion piece by Ben Carlson, the Director of Institutional Asset Management at Ritholtz Wealth Management, on how bond bear markets aren’t measured by losses alone.
• A Pacific Investment Management Co. primer on bonds and the impact of inflation on fixed income returns.
• The investment outlook archive of onetime bond king Bill Gross, with essays addressing the asset allocation implications of inflation.
• An Odd Lots podcast interviewing Macquarie Capital strategist Viktor Shvets on the risk that central banks raise rates too quickly and flip the world into a recession.
More stories like this are available on bloomberg.com
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