Telemus Weekly Market Review September 26th - September 30th, 2022
Bond yields continued their rise this week, leading to lower prices as the bond market barometer, the Bloomberg U.S. Aggregate index, lost -1.0%. Year-to-date, the index has now retreated -14.6%. This is likely to mark what will, by a wide margin, be the worst year for the Bloomberg U.S. Aggregate index since its inception in 1976. So, what has caused such a challenging year, and should one be more cautious of bonds going forward?
Returns from bonds come from a combination of coupon income and price appreciation/depreciation. Coupons are contractual interest payments and typically paid twice a year. Since bonds can be purchased above or below their par value (the amount received when the bond matures) then a bond investor’s return will also be impacted the appreciation/depreciation in price as the value ultimately converges toward its par value at maturity.
The price of a bond is highly sensitivity to prevailing market interest rates, which is a major input in the bond price calculation. The price of a bond moves opposite that of interest rates. During 2022, interest rates have risen based on expectations of the Federal Reserve increasing its target interest rate, the federal funds rate, in response to heightened inflation. The federal funds rate is an overnight lending rate and Treasury yields react to expectations around the future level of the fed funds rate. For example, as the Fed has increased its projections and actions around rate hikes, the 2-year Treasury now sits at a yield of 4.3%, up from just 0.6% to start the year. This size of a move has had a highly negative impact on bond prices, and thus returns.
Given the rise in rates, as of September 30, 2022, the Bloomberg U.S. Aggregate index now carries a yield of 4.75%, up from 1.75% at year end 2021. The weighted average coupon is 2.6%, meaning bond owners are, on average, buying bonds at a discount to par value and thus getting compensated through a combination of semi-annual interest payments and capital appreciation. A yield of 4.75% for the U.S. Aggregate index is the highest yield bond investors have been able to earn since 2008. We view this to be an attractive yield and perceive it as positive for prospective long-term returns going forward.
Historic yield (yield-to-worst) on the Bloomberg U.S. Aggregate Index
Source: Bloomberg
Given that we are more optimistic around longer-term returns for bonds, this doesn’t mean that returns in the short-term will be outsized. Bond results will be dependent on the combination of additional rate hikes by the Fed, beyond what is presently forecasted, as well as the risk appetitive of investors to accept risk in spread sectors, or parts of the bond market beyond Treasuries, where the risk of default (not making coupon or principal payments) exists. Given these uncertainties, one can’t be confident that the drawdown for bonds is over. However, the benefit of how bonds are structured is that as long as the underlying issuer doesn’t default, you are able to get the par value of the bond, plus coupon payments, as a return. For an investor buying a single bond today with a yield of 4.75% that matures in 2027, they know that they will generate that yield over the next five years, if it doesn’t default. The return may not be generated evenly over the five-year period, but over the course of the five years the return will be recognized. This offers more predictability to bond returns than we get from stocks, which have no par value or maturity date, and hence greater ambiguity around their return profile.
Thus far, 2022 has been the most challenging year on record for bonds. Not only have returns been solidly negative but they’ve done so in a year where stocks prices are also down over 20%. We came into the year with muted long-term expectations for bonds given their low yield. Given what has transpired this year, those expectations have now change. For long-term investors that are willing to weather through the ups and downs of the market, we find the current environment to be more attractive for long-term bond investors given where yields sit today.
All opinions expressed in this article are for general informational purposes and constitute the judgment of the author(s) as of the date of the report. These opinions are subject to change without notice and are not intended to provide specific advice or recommendations for any individual or on any specific security. The material has been gathered from sources believed to be reliable, however Telemus Capital cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. PAST PERFORMANCE IS NOT A GUARANTEE OF FUTURE RESULTS. Investment decisions should always be made based on the client's specific financial needs, goals and objectives, time horizon and risk tolerance. Current and future portfolio holdings are subject to risk. Risks may include interest-rate risk, market risk, inflation risk, deflation risk, currency risk, reinvestment risk, business risk, liquidity risk, financial risk, and cybersecurity risk. These risks are more fully described in Telemus Capital's Firm Brochure (Part 2A of Form ADV), which is available upon request. Telemus Capital does not guarantee the results of any investments. Investment, insurance and annuity products are not FDIC insured, are not bank guaranteed, and may lose value. Any reference to an index is included for illustrative purposes only, as an index is not a security in which an investment can be made. Indices are unmanaged vehicles that serve as market indicators and do not account for the deduction of management fees and/or transaction costs generally associated with investable products. The S&P 500 index includes 500 leading companies in the US and is widely regarded as the best single gauge of large-cap US equities. The Bloomberg Barclays US Aggregate Bond is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market.
Advisory services are only offered to clients or prospective clients where Telemus and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Telemus unless a client service agreement is in place. All composite data and corresponding calculations are available upon request.
