Bond Math Suggests Better Days Could be Ahead
Our latest articles stemming out of our annual Capital Market Assumptions (CMAs) research focused on equities and other risk assets, but we wanted to take a moment to highlight the crucial role that bonds play in portfolios and offer perspective on the improving forward outlook for the asset class.
Bonds endured a period of weak performance, highlighted by double digit losses during 2022 when inflation caused bond yields to rise precipitously. The negative impact of rising interest rates created a bear market in fixed income that coincided with significant equity market volatility and led to a perfect storm for investors in balanced portfolios. The experience of 2022 left psychological scars that caused many investors to shun bonds in recent years, but even with the potential for inflation to put further upward pressure on yields in years to come, the “math” suggests that investors should remain patient.
Investors in fixed income are merely lenders that made a loan to a borrower. The borrower is required to make fixed payments (coupons) at regular intervals before paying back the full principal of the loan at maturity. As a result, fixed income investors possess specific knowledge about future cash flows that allows them to precisely calculate their expected return; something that cannot be said for investments in other asset classes.
In the interim period between purchase and maturity, bond returns are influenced by two things (assuming the borrower does not default); the fixed coupon payment and the sensitivity of the bond’s price to changes in prevailing interest rates which might render the bond more or less attractive on a relative basis. This allows us to project returns in the bond market with a relatively high degree of accuracy, as shown below:
Applying this same principal to recent history yields similar results. In April of 2024, the yield on the Bloomberg US Aggregate Bond Index was 5.25%, and the duration was just over 6 years. During the following 12 months, the 10 Year Treasury yield declined by 20bps, which should have translated to roughly a 1.2% gain in terms of price. On top of the price movements, investors would have collected the 5.25% yield, suggesting an implied return of 6.45%. In reality, the index produced a 6.11% return over that twelve- month period, with the difference in forecasted and actual returns reflecting nuances in the shape of the yield curve and changing yields throughout the year.
The primary benefit of this exercise is that it helps to illustrate the improved position of fixed income on a go-forward basis. In 2022, the index was yielding just 1.75%, and so when yields soared higher as inflation accelerated, there was no income cushion for investors to fall back on. Now, fixed income investors can expect to clip about 5% from their bond holdings, which provides insulation against a scenario where yields climb due to a resurgence of inflation. With public equity market valuations elevated, owning diversifying assets that can provide stable income during bouts of volatility is an important way to mitigate portfolio losses in a downturn.
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