For over a decade, savers in investment-grade bonds have watched their yields trend from poor to worse. But with inflation surging, recent speculation on the
Our thesis is that investors should expect to adapt to a new norm for bonds: diminished increases in yield and lower total return compared to prior rate normalization cycles.
That’s not to say there won’t still be plenty of volatility, but if prior cycles are a guide we would not be surprised if bond yields conclude the end of the cycle at a level near where they started at the onset of rate hikes.
As markets enter 2022, the yield on the US Aggregate index sits near 1.75%. While we don’t foresee a rapid increase in yields bloodying the nose of bond markets, we acknowledge that this has happened in the past, it could happen again and investors should be prepared.
Leveling expectations
Wouldn’t it be nice if someone from the future could return to tell markets where rates are headed? Conveniently, the Fed has been doing just that for nearly a decade with its
Unfortunately, delivering on its messaging has been a problem for the FOMC. After nearly a decade of dot plots, it has yet to get the fed funds rate up to a level it previously stated as its intent. In fact, the FOMC’s self-produced estimate of where the long-term target actually is has been in consistent decline since it began issuing its dots, steadily walking down its guidance from 4.5% in 2012 to 2.5% where it sits today.
This trend predates the COVID-19 pandemic, the trade wars that captured market attention in the late 2010s and the multiple rounds of debt-ceiling brinkmanship and fiscal politics, which suggests something fundamentally and powerful is going on below the surface. From where we sit, history suggests a total increase of 225 basis points as the most one should reasonably expect from the next hike cycle. Fed funds futures and overnight index swaps — two market-traded indicators — agree with this assessment, currently suggesting total increases of about 100 to 150 basis points in the fed funds rate through 2024.
Weighing in light
How would 100 to 150 basis points added to the fed funds rate compare with previous cycles? Prior to 2008, the Fed was consistently able to conduct increases of between 350 and 425 basis points during normalization cycles as the U.S. economy exited recession. During the most recent hike cycle however, from December 2015 to July 2019, the Fed was only able to raise its key rate by 225 basis points — just over half the typical magnitude of increase in prior iterations.
How do fed funds rate hikes typically translate into bond market yield levels earned by investors? Generally, we have seen bond yields rise alongside the fed funds rate – but not by the full magnitude. And, following the trend of diminishing magnitude of increase in the fed funds rate with each new cycle, the increase in bond yields has also fallen.
Prior to the 2000s, yields on the Bloomberg US Aggregate Index (the Agg) increased by nearly 250 basis points from where they started at the first hike to their peak yield in the cycle. During the last two hike cycles in the 2000s and 2010s, however, investment-grade bonds added on just slightly over 100 basis points at the peak of their yield expansion. Again, this data suggests low expectations going forward.
Finally, history shows bond yields are trending toward a pattern of ending up at about the same level at the end of the cycle as where they began. From start to finish, there is a strong chance yields end up in the near vicinity of where they started. The data points to the conclusion that it is getting harder for bond markets to pick up, and hold onto, additional gains in yield.
So what does this suggest for bond market returns? Over recent historical hike cycles, bonds have produced shrinking total returns with each passing iteration, largely attributable to the persistently declining levels of yield where bonds entered each new cycle to begin with. If markets generally behave in line with trends, prior results suggest an expected annualized total return closer to zero for bond markets than many might currently assess.
‘Surprise’ returns?
Finally, what about a surprise return counter to what most would consider “normal” yields? The 1990s hike cycle offers an interesting outlier in comparison to its peers. In 1994, yields on the Bloomberg US Aggregate Index rose nearly 250 basis points in about nine months — a massive increase in a compressed time frame. But while investors must have been delighted to derive more income from new bond purchases, they did have to absorb price declines on their existing bond portfolios due to rising yields. The net result was a -3.99% annualized total return for bond investors during those nine months. Not great, but tolerable — if only because yields at 8.3% certainly helped cushion the blow.
Today’s bond investors don’t have that kind of shield. With present bond market conditions, this snapback would offer a completely different experience for investors: a 250 basis point increase in yield on the Bloomberg US Aggregate over nine months today would likely translate into a portfolio loss in value in the vicinity of 15%. Bond investors longing for a speedy return to normalized yields should be careful what they wish for.
Preparing bond investors
A normalization may result in a lower ceiling for rates, and a rapid normalization may result in a rapid decline in value — two things of which bond investors need to be wary.
Rather, they may need to explore alternative approaches to traditional bond strategies, ones that offer similar diversification and downside protection benefits of bonds while offering better upside. This may involve taking on more risk or mixing bonds with other asset classes with stronger return profiles. These types of alternative strategies may be a bridge to either supplement bond portfolios or to wait out a potentially volatile process of returning to a new plateau for bonds.
