Bonds – Bent, Not Broken

FIVE THINGS YOU SHOULD KNOW

1. Equity Markets – finished mixed this week with U.S. stocks (S&P 500) rising 0.46% and international stocks (EAFE) falling –0.11%  
2. Fixed Income Markets – moved higher this week with investment-grade bonds (AGG) up 0.97% and high yield bonds (JNK) gaining 0.15%
3. Fed Minutes – this week’s release of September’s meeting minutes confirmed policymakers agreed they’re in a position to “proceed carefully” and that policy should remain restrictive for some time. The summary also noted, “a majority of participants judged that one more increase in the target federal funds rate at a future meeting would likely be appropriate.”
4. September CPI – Inflation data showed that the consumer price index rose 0.4% for the month and now sits at 3.7% year-over-year, both slightly higher than expectations. As a result of the increase the real average hourly earnings index fell 0.2% for the month, and now sits just +0.5% higher year-over-year.
5. Key Insight – [VIDEO & ARTICLE] In this week’s video Dave and Tim cover, what exactly is a bond, why are they making headlines today and what opportunities lie within the asset class moving forward. Tim continues the discussion in the article below while sharing some more helpful graphs and historical data to reassure today’s bondholders that better days likely lie ahead.

INSIGHTS FOR INVESTORS

Intro

Bond talk is usually pretty boring, but over the last 18 months, many investors have realized the hidden risk that existed within their portfolios (a topic we discussed back on August 4^th, 2020) and is getting more and more attention in the press.

The past is the past, but where do bond markets sit today?

This week we hope to help you better understand this often “boring” and yet important part of many investors’ portfolios and help provide some context to the question of whether fixed-income markets are “bent” or “broken.”

If you want a more verbal/pictorial explanation, my colleague Dave and I explore/explain this topic in this week’s video as well.

What is a bond?

Bond, debt, fixed income, loan (floating or fixed) … there are lots of descriptions of what essential amounts to a loan from an investor to a government or corporation. And while there can be slight differences to the loan terms conveyed at times by the use of different terminology, in general, and certainly for purchases of this intro to bonds we are just referring to a loan with a fixed coupon rate (interest payment) with a stated maturity (i.e. end date when the principal of the bond/loan is to be repaid.

How do they differ from stocks?

There are of course many differences depending on how nuanced one wants to get but for purposes of this week’s discussion, the big difference we want you to make special note of is that the bond’s ultimate value (barring a default) is far more defined than the value of the stock, with the latter being more theoretical and in part based on future projections of profitability.

By contrast, a bond is valued based in part on the dollar amount of the debt owed, and the value of the stream of interest payments over the life of that loan.

Therefore, there is in part a “baseline” value – namely the amount of the debt owed and the present “cost” that debt can be purchased for.

This gives bondholders a greater degree of clarity and confidence as compared to stocks/equities – which is not to say any returns are guaranteed of course.

How did we get to today’s environment for bonds?

First, a quick and general explanation of what drives changes in bond values between the date of issuance and the date of maturity. As Dave describes in the video above, putting aside credit rating changes and taxability impacts, the biggest driver in bond values are changes in interest rates.

As you can see from the first graphic, if interest rates broadly speaking go down that makes existing bonds go up in value as bonds with higher coupons (amount of future interest payments) become more attractive vis a vis bonds with lower interest payments. (see accompanying chart) This dynamic defined much of the period between 1980 and 2022.

Source: Ten Capital 10.23.2023 *For illustrative purposes only

Conversely, if interest rates go up, existing bonds (which lower rates of interest payments) go down in value (see accompanying chart). This of course defines much of what has occurred from a peak in bond values in 2020 during the risk-off peak/period caused by the pandemic which drove the yield on the 10-year Treasury to below 1% until today where the 10-year Treasury has recently hovered near 5% as the Fed rate and other bond yields moved up due to inflationary pressures.

Source: Ten Capital 10.23.2023 *For illustrative purposes only

The Potential Opportunity Amidst the Fog of Volatility

One of the reasons we urged so much caution with regards to investment grade bonds in recent years was because a) the yields on those bonds didn’t even keep up with the rate of inflation meaning investors’ “real return” was negative at best, and b) the majority of existing investment grade debt traded at a “premium” (i.e. at a price greater than the actual amount of debt owed).  In 2020, this resulted in many investment-grade corporate bonds or Barclay’s Aggregate Bond Index trading at approximately 10% above the actual par price (e.g. debt owed to the holder at the maturity of the bond). (see the following graphic illustrating how bonds can trade above and below the debt owed prior to maturity of the bond).

Source: Ten Capital 10.23.2023 *For illustrative purposes only

By contrast today the Barclay’s Aggregate Bond Index (mix of corporate and government bond issuances) trades at approximately a 13% discount to the par price owed. (see the following graphic) With investment-grade corporate bonds trading at slightly higher but similar levels.

What does this mean for investors considering bonds/fixed income today, or currently holding such positions?

In short, while day-to-day moves in global interest rates can impact their positions’ stated value in the short term, eventually as their current holdings mature not only will they continue to receive the stated interest payments but will also see the majority of the current “discount” to par returned to them in the form of additional capital appreciation from today’s levels. While bondholders/buyers returns can be impacted by buying bonds at a premium or discount to par, ultimately at maturity the borrower only owes the debt holder the original amount borrowed (i.e. par price).

The takeaway from this is not to guarantee any type of return or forecast any future volatility in either direction for interest rate moves, but rather to explain the added security/potential in terms of one’s initial investment along with the interest that high-quality bonds bought at a discount have relative to many other types of investments.

The only real exception to this for investors that hold such fixed-income investments until maturity? A default (failure to pay) by the debtor.

So what does history have to share with us regarding this risk?

According to a well-done article by the team at Rutherford Rede out of New Zealand on the historical default risk of bonds, “If you look at the BBB rated bonds (lowest rated investment grade bond), based on historical data, there is a 1.60% expected probability of default over a 5-year period …And across the aggregate of Investment grade bonds (AAA to BBB), the expected probability of default is 0.82% over 5 years, compared to 7.37% for Speculative grade bonds.” (see accompanying chart)

Date: 4/7/23

As you can see from the chart above, while history is no guarantee of the future, over the last 40+ years ending 2022 there has been no time period where defaults among high-quality bonds (AAA to BBB) had a default rate even half as great as the current discount to par such bonds currently are trading at today.

That is why at this point we believe bond investors need to look past the noise of headlines and impacts of short-term interest on bond values to keep in mind the current opportunity presented today.

Have a wonderful weekend,

Tim and the team at TEN Capital

DATA, JUST THE DATA

U.S. Jobless Claims – remain unchanged from the prior week at 209,000 on the week ending October 7^th. This fell below estimates of 210,000 and remains close to the seven-month low of 202,000 from September.

U.S. Mortgage Applications – edged higher by 0.6% on the week ending October 6th, following the 6% drawdown from the prior week according to data from the Mortgage Bankers Association.

U.S. Export Prices – rose by 0.7% month-over-month in September 2023, which was above market expectations of a 0.5% gain. This was following a 1.1% advance in the previous month.

U.K. Monthly GDP – rose by 0.2% month-over-month in August 2023, matching market estimates while shifting from a revised 0.6% contraction in July. 

Eurozone Industrial Production – increased by 0.6% MoM in August 2023, partially rebounding from July’s 1.3% contraction which surpassed the expected increase of 0.1%.