Think Stocks are Volatile? Take a look at Bonds

Think Stocks are Volatile… take a look at Bonds

Did you know the Aggregate Bond Market (as measured by AGG) and the Dow Jones Industrial Average are both down almost 10% year-to-date 2022?  If investors think stocks are volatile, they need to consider bond price action as certain segments of the bond market can be just as volatile as stocks when requisite conditions exist. 

All too often bonds are viewed with a homogenous lens; however, bond markets are bigger and broader than equities and need to be approached with precision to identify opportunities for gains, but also avoid unnecessary losses during times of market stress.

As previously highlighted in our piece Too Conservative Is Risky, we noted the following:

“Some would argue that if you hold the bond to maturity and there is no default, you’ll receive the interest and your money back.  This is true; however, if you invested in a 10-Year U.S. Treasury today with an interest yield of approximately 2.3%, then any inflation above that level means the investor is losing money over time (10 years in this example) on a ‘Real’ basis; i.e. less purchasing power overall.  Additionally, that bond will experience volatility in price/value, so one must be prepared to hold for the full ten-year term.  Therefore, the buying and holding of individual bonds for long periods of time can be a risk unto itself.”

The point of the above is that over longer periods of time there can be price stability.  To illustrate, a bond when issued has a value, call it par value at $100.  Upon maturity the investor will receive their initial face value of the bond back or $100.  Independent of the interest rate environment and inflation over the term, the price is the same at issuance and maturity = stable. 

However, it is exactly the point that the $100 value will fluctuate in value between issuance and maturity.  Why?  A fixed interest rate does not change, for example 3.0%, but the world and market around it does. Therefore, as the interest rate is fixed the only way the bond can achieve equivalency to current market rates is through the movement of the underlying value away from $100, either downward (discount) or upward (premium) to par value. 

To build upon our example, if a 10-year bond is paying 3.0% on the day of issuance at $100 and the next day the market demanded an identical bond being issued to pay 4.0%, no investor will want to buy the 3.0% bond.  Therefore, the bond paying 3.0% needs to drop to approximately $90 creating an equivalent payment over time; a point of indifference between the two offerings.

Here’s the math for illustration: 

• 3.0% Bond realizes $30 of Interest over 10-year term + $10 of appreciation (from $90 to $100 at maturity) = $40 of total value to be realized,

• 4.0% Bond realize $40 of Interest over the 10-year term = $40 of total value to be realized.

What readers can infer from the above example is that the longer the term of the bond the more it drops in value as rates rise.  Continuing with our very simple illustration, a bond with a 20-year term can drop in value to $80, while a 5-year term bond drops in value to $95. 

Therefore, in the current rising rate environment we believe the best portfolio positioning is short term and variable rate securities in an unconstrained approach.  Consequently, among other tactical moves, this is where Clearwater Capital has currently positioned client bond holdings.

To move beyond a hypothetical example where interest rates may not move 1% point overnight, the 10-Year U.S. Treasury Bond Yield is up approximately 1.3% points already in 2022 through April 28th as illustrated below (MarcroTrends ^TNX):

Consequently, the Aggregate Bond Market, as measured by ticker “AGG”, has dropped by over 9% from a value level of approximately 113 to under 103.  In a low interest rate environment, there is no way for interest payments to offset such drops in bond values. 

If one thinks all bonds are the same, bonds are boring, or bonds are not an important segment of financial markets worth their time for consideration … they are sadly mistaken.  Bonds can be volatile and are subject to significant movements.  Even if we only focus on Government Bond (aka Sovereign Debt) annual returns, one can observe wide variation in the below table:

Yes, there are times in history when significant moves, upward and downward, for bond values can be witnessed.  However, if readers believe this year has felt particularly volatile, they’d be correct.  Bespoke observed, “During this 45-year span [since 1977], there have only been five other months where stocks fell more than 5% and bonds dropped more than 2.5% in same month. That's less than 1% of all months.”  Bespoke went on to share that April 2022 was the 2nd time this year.  In other words, the level of volatility we’ve witnessed in both stocks and bonds has happened six times in 45 years, including twice in 2022.  That is a lot of volatility.

Clearwater Capital has taken a tactical approach toward managing Fixed Income components of client portfolio strategies.  Over the years we have written extensively about different roles Fixed Income can play in portfolio strategy, whether it be as a diversifier to stocks or part of total return structure.  Our approach will always be guided by the evolving world around us and our thesis of what is to come.  We do NOT take a ‘buy and hold’ approach (and do not know why someone would buy a 10-year Treasury Bond with an intention to hold it for 10 years).  Our unconstrained approach to fixed income has allowed us to include a wide array of securities believed appropriate for portfolio construction whatever the world may have in store for us. 

John W. Sleeting

Executive Partner