BACK TO THE BOUTIQUE INVESTOR BLOG Helping Clients Make Sense of the Bond Market Kevin T. Cooper, CFA VICE PRESIDENT | HEAD OF INVESTMENT RESEARCH In a year of tumultuous markets, one of the questions advisors are fielding from concerned investors is: Why aren’t bonds protecting me? It’s a fair question. As of late August, the total return for the Bloomberg U.S. Aggregate Bond Index, the benchmark for investment-grade bonds, was down more than 10% for the year. Other bond indices are taking a beating, too.1 Because stocks and bonds are not typically correlated, investors may be confused and frustrated that their bond holdings don’t seem to be providing a haven amid a bear market for stocks. The underlying, indirect cause of the bond slump is inflation, fueled by economic recovery from the Covid-19 pandemic, supply-chain snarls, government stimulus, the war in Ukraine, and other factors. The more direct cause is the Federal Reserve, which has been aggressively hiking interest rates to fight inflation. Higher interest rates cause bond prices to fall: New bonds issued at higher interest rates make existing bonds at lower rates less attractive on the secondary market. Add to this the U.S. Treasury’s quantitative tightening—the government is buying fewer bonds—and investors wonder: Is it time to get out?2 Advisors can assist their clients by reminding them of the big picture, reinforcing the fundamental benefits of bonds, even in a year when few investments feel safe. Bonds May Offer Income Stability and Mitigate Portfolio Risk Bonds, unlike equity investments, are loans with a set of specific obligations to the issuer over a set period. Bond investors essentially are lenders, with the defined benefits of interest payments and the repayment of principal. Government and investment-grade corporate bonds generally have a strong record of safety, and a steady stream of income has a stabilizing influence on investment portfolios regardless of market volatility. Some debt instruments, such as municipal bonds, offer the added benefit of tax-free interest payments at the federal and possibly state levels. Therefore, holding those bonds, even in a down market, can be better than selling at the worst possible time. Bonds are Generally Less Volatile Than Stocks Tough as it is for bond prices these days, the stock market has fared worse: The S&P 500 was down as much at 24% from its highs earlier this year, and even after a rally, was down by 13.3% for the year as of late August. The tech-heavy Nasdaq Composite was down 20.75% in the same time frame, and the stock market overall was down 14.4%.3 In that light, the Bloomberg U.S. Aggregate Bond Index’s roughly 10% decline is less discouraging. Generally, the bond market is less vulnerable than stocks to wild swings on a daily or weekly basis. Bonds Offer Opportunity While it can be frustrating to see current bond holdings drop in price, there is a parallel opportunity for new bond investments. Falling bond prices mean rising yields on debt already issued, and new bond issuances that debut at a time when the Fed is tightening offer higher interest rates. Every client has different needs, but for retirees or others for whom income and low risk to principal are paramount, holding existing bonds while perhaps adding new ones is a strategy worth considering—more so, certainly, than giving into anxiety, selling, and locking in losses. Moving in and out of positions tends to be costly. Research by DALBAR Inc. shows that untimely or excessive buying or selling is the primary cause4 that returns for investors—even in bull markets—typically trail broad market returns. For example, in the first half of last year, the gap in the return between investors and the S&P 500 was 2.11 percentage points. In good markets or bad, advisors serve their clients best by encouraging them to “Keep Calm and Remain Diversified.” This is especially true during periods of decline: Over the last 20 years, during down cycles, the average intra-year decline for the S&P 500 was 15.5 percent, while a diversified portfolio* saw an average drop of less than 9 percent. Bonds may not seem attractive currently, but they remain a key element of a balanced investment strategy, and they offer additional benefits such as stable cash flow and protection of capital. In tough times, those are benefits worth preserving. 1 https://www.wsj.com/market-data/bonds/benchmarks?mod=md_bond_view_tracking_bond_full 2 https://www.wsj.com/articles/shrinking-deficits-cushion-feds-retreat-from-markets-11661095878 3 “The Value of Time: Quantifying how client focus increases the value of your business.” FP Transitions. 2016. 4 https://www.fa-mag.com/news/average-equity-investor-lagged-s-p-500-by-2–in-first-half–dalbar-finds-63697.html?section=3 Past performance is not a guarantee of future results. The views expressed are not intended as a forecast or guarantee of future results, and are subject to change without notice. Any sectors, industries, or securities discussed should not be perceived as investment recommendations. There is no guarantee that any investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for a long term, especially during periods of downturns in the market. Diversification does not guarantee a profit or protect from loss in a declining market. The S&P 500® Index is a capitalization-weighted index of 500 stocks. The S&P 500 Index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The Nasdaq Composite Index is a market capitalization-weighted index of more than 3,700 stocks listed on the Nasdaq stock exchange. The Bloomberg U.S. Aggregate Bond Index is an index of the U.S. investment-grade fixed-rate bond market, including both government and corporate bonds. The indices are unmanaged, are not available for investment and do not incur expenses. *Diversified Portfolio Allocation: Investment Grade Bonds (IG Bonds): 32%, Municipals (Munis): 5%, U.S. High Yield Bonds (US HYB): 5%, U.S. Large Cap Equity: (US LC): 23%, U.S. Small Cap Equity (US SC): 10%, Foreign Developed Equity (For Dev): 10%, International Small Cap (Intl SC): 5%, Emerging Markets (EM): 5%, U.S. Real Estate (REITs): 5%, Alternatives, 5%. Source: Barclays, Bloomberg, Dow Jones, FactSet, MSCI Russell, Standard & Poor’s as of December 31, 2021. The indices are unmanaged, are not available for investment, and do not incur expenses. Click here for index definitions. The diversified portfolio is rebalanced to the original allocation annually. The performance shown is not indicative of the performance of any mutual fund or other investment product. Past performance is no guarantee of future results. © Copyright 2022 AMG Funds LLC. All rights reserved.