How bad can this bond crash be? | Financial advisors
Bond prices have been in freefall for about five months. This means that financial advisers who use bonds and bond portfolios in their practices need to do something they’ve probably never had to do: explain to panicked clients why the part of their portfolio designed to offset risk of their equity investments fails them.
Bond price declines happen so quickly and with such large downward moves, it’s fair to say that advisors and their clients have never had to deal with this. Now they have no choice. Just hoping things will get better is too dangerous for those who are retired or approaching retirement.
The point of no return ”
From the beginning of December 2021 through market close on May 4, the total return, including income, of the iShares Core US Aggregate Bond Exchange-Traded Fund (ticker: AGG), a commonly used benchmark for investment grade bond market, is down about 10%.
The iShares iBoxx $ Investment-Grade Corporate Bond (LQD) ETF is down about 15%.
Meanwhile, the iShares 20+ Year Treasury Bond (TLT) ETF, which tracks 20-30 year Treasury bonds, is down more than 20%.
It’s true: investors in long bonds have seen a fifth of their investment disappear in five months.
High-yield bonds fell just 5%, but are just as vulnerable as other bond classes, if not more, due to their low credit quality and rapidly deteriorating corporate credit conditions. heavily in debt. The Federal Reserve has come to their rescue for the past six years, but the Fed has a lot on its mind right now and seems determined to fight inflation at the cost of almost everything else…including prices. bonds in your clients’ portfolios.
Here are three possible paths from there that help counselors understand what is possible and begin to calm nerves and introduce alternative solutions.
Path 1: This is the end
In this case, it is the end of the decline.
Interest rates seem a little stretched higher, which means that bond prices may have seen the majority of their declines so far. But a break from the calamity might be the best situation for advisors because they can catch their breath, explain to their clients what happened, why it happened, and work with them to determine if they’re ready. to get out of it. At some point, rates will peak and decline. But the longer-term graphical view of interest rates and bond prices makes this more of wishful thinking than a blueprint on which to build your firm’s reputation and earnings.
Buying the dip worked for a while for stocks, and it could work here and there for bonds. But until the long-term downward trend in prices, the upward trend in interest rates and worries about credit conditions and liquidity are reversed for good, the idea that everything it was just a bad dream maybe far fetched. Investors are unlikely to wake up any time soon to a whole new bond bull cycle. So for advisors, it’s not a problem you can ignore and hope it goes away.
Path 2: We have just begun
In 2020, certain types of bonds crashed along with stocks. But these are the types most correlated to stocks, such as preferred stocks, convertibles and high-yield bonds. In contrast, Treasuries were strong, if not spectacular.
At the time, investors were fleeing to the perceived security of Treasuries. This time around, Treasuries are at the heart of the matter, as the Fed is forced to raise short-term rates, and long-term rates are hijacked by bond market bears.
Meanwhile, recession fears have been stoked because one of the most reliable indicators of economic contraction, the 10-2 Treasury yield spread, has created an inverted yield curve. More importantly, he quickly returned to his normal, upward leaning shape. That is what, historically, sets off the countdown to recessions.
But this recession may be different from any recession in recent memory: it is accompanied by high inflation. But this economic stagnation combined with galloping inflation threatens to lead to “stagflation”. It’s about the worst economic situation besides a depression.
You see, rising prices are acceptable if the economy is growing. When growth isn’t there, you experience rising prices without a commensurate increase in employment, consumer spending, and other economic stimulus. Do a search on “economics of the 1970s” to learn more about it. Most investors today only know this if they read it in college economics.
Path 3: The long and winding road
This path focuses on China. Given China’s latest economic stall due to strict COVID-19 lockdown policies, investors can expect further negative impacts from China’s limited economic output as well as its need for certain goods.
A low-growth, constrained China is part of a long-term malaise scenario, where the pace of bond price declines slows and rates rise at a slower pace, but the trend remains stubbornly higher until let inflation be crushed by the Fed and other centrals. banks.
It’s not hard to imagine why this scenario is realistic. Investors spent 12 years in economic conditions where no matter how much money people wanted to borrow, they could. Now that they have to repay, and rising rates combine with floating payment rates to squeeze consumers, it all comes together…in a bad way.
To make matters worse, China is one of the largest holders of US Treasury debt. If the government of this country decides to pursue much more nationalistic policies than it already does, it may sell more of its holdings to the Treasury as part of this mission. This could be another technical factor contributing to long-term stress for bond investors.
Silver-Linings Playbook for Advisors
At some point investors will look at their screens and see higher rates than they have seen in a long time. Then they will see those rates start to drop, and then even more. This could finally be the time when bonds can go from where they are today (a disaster zone, threatening to get worse) to where they were in the 1980s (an opportunity to lock in excellent returns long-term, anti-inflation at levels that can even rival long-term stock market returns).
It is quite likely in the future. But getting to that point will likely be one of a few paths that advisors and investors will have to endure.
That’s why now is the time for counselors to use this as a teachable moment. This bond crisis may prompt advisors to change the mindset of clients about the tools they are using to achieve their goals instead of a predicament that only compounds their stock market problems.