Most investors have bonds in their portfolio to protect against stock market falls, but when stock markets fell last year, bonds fell too, and they are not performing well this year either.
Back in blog post 'Investing Terminology', we identified the role of bonds and equity in an investment portfolio and how a balance between the two can reduce volatility and risk. But, this hasn’t really worked in the last 2 years.
In 2022, the bond fund market witnessed a seismic shift, leaving investors bewildered by the sudden crash in prices. In this blog, we unravel the complexities of this phenomenon, exploring the intertwined relationship between bond funds, rising interest rates, and surging inflation.
What is a Bond Fund?
Think of a bond as a loan you give to a company or government, and in return, they promise to pay you back with interest over a set period.
Suppose Company ABC wants to raise £1M to fund a new project. Instead of borrowing from a bank, ABC decides to issue bonds. Each bond has a face value of £1,000, an interest rate of 5%, and a maturity period of 5 years.
Investors who buy these bonds are essentially lending money to Company ABC. In return, ABC agrees to pay them £50 in interest per year (5% of £1,000) for five years. At the end of the 5 years, ABC will return the original £1,000 to the bondholders.
Enter the Bond Fund: Now, imagine you want to spread your bets; this is where bond funds come into play. Instead of putting all your money into one bond, you pool your cash with other investors. The fund manager then uses this money to buy a mix of bonds—some from the government, some from companies, creating a diversified bond buffet. Your return from the bond fund would come from the interest earned by the entire portfolio, but the value of your investment in the fund may fluctuate based on changes in the bond market and the global economy.
Bond Duration is Ultra-Important
Bond prices change with interest rates; when rates go up, bond prices go down, and vice versa. The magnitude of the effect varies with the amount of time left until the bond matures, the bond face value, and the interest rate paid. If a bond matures next week, a change in interest rates tomorrow will have very little effect on its price. If it matures in 30 years, then even a small change in rates will have a big impact. Duration is a measure of this.
Understanding what a fund holds is vital to gauge potential returns and risks, for example:
1. iShares Index-Linked Gilts 0-5yr Fund only buys UK government index-linked bonds maturing in 0-5 years. This fund holds just 17 bonds presently. As these bonds mature, the fund manager reinvests the cash to maintain the 0-5 year mandate. It’s like a conveyor belt – as bonds fall off the end, more get added to the front.
This fund has a short duration due to its focus on the 0-5 year maturity range. Given the shorter duration of this fund, it has experienced less impact from interest rate hikes compared to funds with longer durations.
2. iShares 20+ Year Treasury Bond fund LTL tracks long-term U.S. Treasury bonds. In the rising interest rate environment, the LTL fund has experienced more significant price declines due to its longer duration.
3. Vanguard Global Bond Index Fund provides exposure to a broad range of global bonds from governments and companies, with a variety of durations. It offers investors a chance to diversify across different markets, currencies, and durations. With an overall medium term duration, the Vanguard Global Bond Index Fund has experienced less volatility than LTL.
Why Have Some Bond Fund Prices Crashed Recently?
Bond funds have long been regarded as a safe haven for investors seeking stability and regular income. However, the events of 2022 have shaken this perception, leaving many wondering why these seemingly secure investments experienced a sudden and sharp decline in value.
One of the primary culprits behind the bond fund price crash is the surge in interest rates. In 2022, central banks worldwide responded to inflation concerns by adopting a hawkish stance on monetary policy. As interest rates rose, the fixed-interest payments offered by existing bonds became less attractive in comparison to the higher yields available on newly issued bonds.
Imagine you hold a bond with a fixed interest rate of 3%, and suddenly, new bonds are being issued with a higher rate of 5%. The market value of your bond decreases because its fixed interest rate is now less appealing in the face of higher-yielding alternatives.
Inflation, the silent force affecting the purchasing power of our money, also played a significant role in the bond fund price crash. As inflation rates soared, the real value of fixed-income payments from bonds diminished. Investors, fearing that inflation would erode the purchasing power of their returns, sought refuge in cash, thus decreasing the market value of bond funds further.
The confluence of rising interest rates and surging inflation created a perfect storm for bond funds. Investors faced a double whammy as the attractiveness of fixed-interest payments dwindled amidst a backdrop of economic uncertainty.
If your bond fund crashed 20-30% in the past year, the culprit is very likely high duration:
· Vanguard Long Duration Guilt Index Fund over the last 3 years has fallen 47%
· Vanguard Global Bond Index Fund has fallen 13%
· Vanguard U.K. Short-Term Investment Grade Bond Index Fund has fallen 4%
Why Haven't Bond Funds Hedged Falling Stock Markets?
While bonds are generally considered less volatile than stocks, their ability to act as a reliable hedge is not foolproof. The correlation between bond and stock prices can be influenced by various factors, including economic conditions, interest rates, and investor sentiment. In times of economic uncertainty, correlations may shift, and both stocks and bonds can experience losses simultaneously.
As mentioned earlier, the surge in interest rates was a key factor in the bond fund price crash. When interest rates rise, bond prices tend to fall. This inverse relationship can undermine the protective role that bonds traditionally play in a diversified portfolio. In 2022, the double whammy of rising inflation following the Covid pandemic, followed by Government attempts to control inflation by raising interest rates, not only affected bond fund returns but also contributed to the drop in stock markets.
During periods of market stress, investors often flock to perceived safe-haven assets, which has seen mass migration of funds to cash and short term bonds, thus lowering the returns from medium and long term bonds.
Bonds and stocks usually move in opposite ways, except in certain scenarios. High inflation is toxic for both assets, breaking their negative correlation. In 2022, inflation shocked markets globally, causing both bonds and equities to sell off together. So the hedge didn’t work when it was needed most!
Why Didn't Investors See the Fall Coming?
The 2022 bond fund price crash and the subsequent market dynamics have left many investors wondering why the downturn caught them off guard. Hindsight is often 20/20, but the events leading up to the bond fund price crash were marked by unprecedented economic conditions, including a global pandemic, and war in the Ukraine, leading to rapid rises in inflation not seen in decades, and the subsequent response of central banks increasing interest rates at a speed and amount not seen for decades.
The scale and speed of policy adjustments, combined with the unique challenges posed by the pandemic, created an environment that defied traditional economic models. Investors and analysts alike found themselves navigating uncharted waters, making it difficult to predict the precise impact on financial markets.
The bond fund price crash of 2022 resulted from a complex interplay of rising interest rates, inflation concerns, and shifting investor sentiment. Predicting the precise combination and timing of these factors is a formidable challenge that even seasoned experts may find elusive, and the combination of soaring inflation and rising interest rates was not a scenario that had played out in recent history. Investors often rely on historical data to inform their decisions and anticipate market movements. However, the absence of a clear historical precedent for the specific conditions of 2022 made it challenging for investors to draw accurate parallels and foresee the extent of the impact on bond funds.
Human nature tends to gravitate towards patterns and past trends as indicators of future outcomes. In times of prolonged market stability, investors may become complacent and assume that existing trends will persist. The rapid and unexpected changes in economic conditions served as a wake-up call, highlighting the importance of questioning assumptions and staying vigilant in the face of evolving market dynamics.
What Happens When Inflation and Interest Rates Fall?
When inflation and interest rates fall, bond prices tend to rise. As fixed-income securities become more attractive in a low-interest-rate environment, bond funds may see a recovery in their prices. Investors holding bonds with higher coupon rates may experience capital gains as the value of their existing bonds appreciates in response to falling interest rates.
Historically, equities have performed well during periods of low inflation and interest rates. Lower borrowing costs can stimulate economic activity, benefiting companies and potentially boosting equity prices. Investors may find equities more appealing in a low-rate environment, seeking higher returns than those offered by fixed-income investments.