Bond returns have been disappointing in 2022. That said, we believe individual bonds remain the best way to generate income, maintain control, and preserve liquidity.
Why have bond returns been so poor in 2022? The starting level of interest rates was quite low due to the extraordinary steps taken by the Fed in response to the pandemic, and the starting point matters a great deal. High inflation and the return to post-pandemic normalcy meant the Fed had to shift policy and begin raising interest rates since stimulus was no longer necessary. The uncertainty regarding the extent of the Fed’s future rate hikes, along with the potential for high inflation to persist, led the general level of interest rates to rise (recall the Fed only controls the overnight rate).
When interest rates rise, bond prices fall — all other things equal. For example, assume a bond has a 3% coupon and trades close to par value, or $100. If prevailing yields rise to 4%, the bond paying 3% is not as attractive, and therefore its price must fall in order for its yield to rise to 4% to be in-line with the market.
There are various options for gaining exposure to bonds and there is a huge difference between owning bond funds and individual bonds. In a bond fund, the investor has exposure to changes in interest rates, but the bonds in the fund are traded frequently and there is no set maturity or end date to the fund. Contrast that with owning individual bonds, which allows the investor to maintain control over the trade decision for each holding. If taking realized losses is helpful, the investor can select which bond to sell. Holding the bonds to maturity will result in no realized losses, all other things equal. Owning individual bonds also allows for a tailored approach to risk management, allowing for tactical or strategic strategies which can easily be adjusted as an investor’s economic profile evolves.
A primary concern keeping investors away from bonds in recent months appears to be their negative performance. This year is just the fifth since 1982 for negative returns to hit broad bond market indices. Now that coupon income is substantially higher, the likelihood of another year of negative returns is substantially reduced.
Exhibit 1 compares the yield on the 10-year US Treasury Note to the dividend yield of the S&P 500 Index. The chart shows that as of late November 2022 yield-oriented investors can achieve higher yields from bonds than has been available in many years. There are many ways to obtain this yield aside from ten year Treasury notes, and some individual equities feature higher dividend yields than the index, but the point remains valid that bond yields are now once again a compelling alternative.
Bottom line: lower prices mean higher yields, and investors are now able to enjoy the highest yields in years thanks to repeated Fed rate hikes along with higher risk spreads.
Most Fed Watchers expect at least several more rate hikes. Does this mean investors should wait for prices to move even lower before buying bonds? While it is possible bond prices will decline more, which may send yields even higher (depending on risk spreads), it’s quite possible that market prices already reflect these anticipated moves, and the peak in yields may have already been reached. Furthermore, we are not fans of attempting to call the top or the bottom in markets — that’s what we call a loser’s game.
While more rate hikes appear likely, the latest reports suggest inflation may have peaked and any meaningful progress in future inflation reports could influence the market’s expectations of additional rate hikes. As well, if the Ukraine war ends abruptly for whatever reason, energy commodity prices would likely move lower which would relieve some inflation pressure and could alter the Fed’s plans for additional rate hikes.
The higher yields now available in the bond market are a welcome change for investors. The proceeds from maturing bonds can be reinvested at yields not seen in a decade. This will provide solid income whether taxable or tax-exempt. There may also be rebalancing opportunities as gains in some investments can be realized and offset with realized losses to minimize tax obligations.
The take-away: now that interest rates have risen to levels not seen in many years, prevailing yields are substantially higher, providing a much bigger cushion to future price action. Said differently, when YTD total returns are this bad, the prospects for future total returns are quite attractive
Important Disclosures
Maple Capital Management, Inc. (MCM) is an independent SEC Registered Investment Advisor with offices in Montpelier, Vermont and Atlanta, Georgia.
This commentary reflects the views of MCM and should not be considered to be investment or financial advice. MCM does not warranty these views and will not update this communication after the date of publication. Any mention of specific securities is done for illustrative purposes and the securities mentioned may or may not be held in client accounts. No assumption or assurance should be taken that securities mentioned will be safe or profitable investments.
For further information, please contact Steven Killoran at 1-802-229-2838 or at [email protected]. For further information about Maple Capital, including a copy of our informational brochure, please visit our website at www.maplecapital.com.
