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Fund Spotlight: Bond Options

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Ask most investors about the year 2022, and they’ll probably talk about the decline in stocks even though last year wasn’t a historically bad year. Outside technology-laden sectors, the other sectors spent little to no time around the 20 percent loss line that most use to define a bear market.

The same cannot be said for bonds. They entered a major bear market in 2020, and it accelerated in 2022. If one investment bank is correct, the 10-year U.S. Treasury bond suffered its worst performance since 1788, a year when much of the world assumed the fledgling United States could fail. Last year, the 30-year Treasury bond suffered larger losses than the Nasdaq 100 Index.

Those losses stopped in October 2022 as investors digested the turn in inflation. Monthly inflation numbers peaked in June 2022 and slumped quickly before accelerating slightly in 2023. If the recent slide in crude oil holds, monthly numbers will turn down again. Crude oil is a very reliable indicator of future inflation, and the current slump could help drag CPI numbers below 4 percent. At that point, the Federal Reserve would very likely hold interest rates steady because the current level of interest rates is a historically normal level for a CPI of between 3 and 4 percent.

Higher interest rates are good news for savers and investors looking to buy bonds. After years of offering zero percent returns, many short-term bond and money market funds offer yields of 4 percent or more. For the bond sleeve of a portfolio, there are a great many potential investments after the rise in rates, with even short- and intermediate-term government bonds offering decent income.

One corner of the bond market that remains volatile is long-term government bonds. These bonds have the longest duration in the market, meaning they have the greatest amount of interest rate risk. The 30-year, zero-coupon bonds are the highest risk. They’ve tumbled more than 50 percent since peaking during the pandemic. At that time, those bonds were “return-free risk,” as some banks are learning these days. It made no sense to have these bonds even as a trade because the upside was highly limited and the downside was not. Pimco 25+ Year Zero Coupon U.S. Treasury (ZROZ) and Vanguard Extended Duration (EDV) have these types of bonds in their portfolios, while iShares 20+ Year Treasury (TLT) has interest-bearing bonds that have somewhat lower duration.

These bonds remain highly aggressive for an investor’s bond sleeve because of their volatility. However, given the decline in the bonds and the relative valuation of equities, there is a case for holding them in place of some growth stock exposure.

There are four ways two assets can behave in relation to each other. Both increase; both decrease; one rises, and the other falls; one falls, and the other rises. In 2022, Invesco QQQ (QQQ) and the three aforementioned long-term bond funds — TLT, EDV and ZROZ — all lost more than 30 percent. Due to inflation and rising rate concerns last year, both bonds and stocks traded similarly.

One possibility is that these bond funds and QQQ will continue sliding together. They stayed largely correlated until the bank failures in March. If they remain correlated moving forward, then we expect the risk for stocks will exceed that of bonds. As the interest rate rises, bonds lose money in a fairly linear manner. However, as we saw with banks in March, at certain levels of interest rates, companies can start going bankrupt. If inflation and interest rates are headed for new highs, bonds will do poorly, but stocks probably will fare worse.

If this scenario plays out, cash or short-term bonds would be a better alternative to either stocks or long-term bonds.

The next possibility is that both stocks and long-term government bonds rally. Both tumbled in 2022, and both have done well in 2023. The Nasdaq pulled ahead as of March 16, with a 15.22 percent return in 2023, while TLT had a gain of 6.27 percent, the lowest of the three bond funds. Investors may not have as much upside with bonds as stocks, but stocks cannot rally much if bonds sell off again.

The next possibility is that bonds fall and stocks rise. We see this as highly unlikely right now. A significant move lower in bonds will pull stocks lower as well though. Investors have already started increasing bond and cash allocations because they offer good income.

The final possibility is that bonds rise and stocks fall. A recession and/or a bear market in stocks could be one way this happens. We have seen this scenario play out multiple times during previous corrections and bear markets. If a recession lowers inflation, it will likely play out again because the Federal Reserve will have some room to cut rates.

In theory, anything is possible, but inflation has peaked for now. The oil price drop in March will help put a lid on inflation in the near term. The past 50 years of economic history show rapid increases in inflation and interest rates, along with a deeply inverted yield curve as we have now, have almost always been followed by a recession within about two years at the latest. However, the last time similar conditions existed was in the early 1980s, and at that time, a recession was almost immediate once the yield curve started steepening. The banking troubles hint at the stress in the financial system. Finally, the Federal Reserve hasn’t thrown in the towel yet. While they did start a bailout for some banks, they aren’t bailing out the whole financial system. That day may come, but it will take greater losses in the financial markets, losses that will likely trigger a rally in government bonds.

Duration

Duration is a measure of interest rate risk. Measured in years, it gives a rough estimate of how much a bond fund or an individual bond will move for a 1 percent move in interest rates. A bond with a duration of 10 would be expected to rise or fall 10 percent for a 1 percent drop or rise in the relevant interest rate.

TLT has a duration of 17.64, EDV 24.23 and ZROZ 26.18.

Volatility

TLT has a standard deviation of 14.82, EDV 19.32 and ZROZ 20.75. TLT has a beta of 2.04 versus the average bond fund, EDV 2.61 and ZROZ 2.73.

ZROZ is riskier than EDV, and both are riskier than TLT.

Performance  

Over the past year, TLT declined 16.64 percent, EDV 21.97 percent and ZROZ 23.84 percent. QQQ fell 10.84 percent.

Year to date, TLT, EDV and ZROZ have increased 8.22 percent, 10.84 percent and 11.49 percent. QQQ gained 14.89 percent.

From their peak in 2020, TLT lost more than 40 percent, while EDV and ZROZ slid 55 percent.

Income

TLT has a 30-day SEC yield of 3.79 percent and pays monthly dividends.

EDV has a 30-day SEC yield of 3.82 percent and pays quarterly.

ZROZ has a 30-day SEC yield of 3.30 percent and pays quarterly.

Outlook

The Federal Reserve launched a depositor bailout program in March. Traders immediately bid up Nasdaq stocks, cryptocurrency and some of the riskiest stocks in the market on the expectation of further stimulus. They also pushed the 30-year Treasury bond back near its 2023 high, along with many short-term bonds.

Aggressive investors might be tempted to buy growth stocks or ETFs  such as Invesco QQQ (QQQ) for exposure. Long-dated government bonds offer solid upside though, while also offering some opportunity if a recession or financial crisis develops. For this reason, investors who want added equity exposure in areas such as growth and technology may be better served by allocating part of that equity slice to longer-term government bonds.

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Market Perspective for April 17, 2023

Market Perspective for April 17, 2023

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The week after the Good Friday and Easter holidays provided traders with several clues about the state of the market. Perhaps the most important clue came on Wednesday when Consumer Price Index (CPI) data was released. It showed that inflation had slowed to 5 percent on an annual basis, which is down from an annual rate of 6 percent in March. In addition, the monthly CPI figure was down1 percent, which was lower than the expected increase of .2 percent.

However, core CPI increased by .4 percent, which means that inflationary pressures may remain even as prices continue to stabilize. The Core CPI figure is generally given more weight by investors and policymakers alike. This is because it ignores food and energy prices that tend to be extremely volatile and may create a distorted picture of current economic conditions.

On Thursday, the Bureau of Labor Statistics (BLS) released its Producer Price Index (PPI). It showed a drop of .5 percent in prices for finished goods and services during the month of March after prices were unchanged in February. Furthermore, unemployment claims rose from 228,000 in the final week of March to 239,000 in the first week of April.

On Friday, monthly core retail sales and overall retail sales figures were released at 8:30 a.m. In March, overall retail sales dropped by 1 percent, which was steeper than the .4 percent drop expected by analysts prior to the report’s release. Core retail sales dropped .8 percent during that same time period compared to an estimated contraction of .4 percent.

Consumer sentiment and inflation expectation reports were released Friday morning. The University of Michigan sentiment index came in at 63.5, which means that consumers are generally upbeat about the state of the economy. This figure beat a consensus estimate of 62 and was slightly higher than figures released in the second half of March.

It was also revealed that consumers expect the inflation rate to be about 4.6 percent over the next 12 months. This is a .8 percent increase since the previous month and is the highest figure since December 2022 when consumers also expected inflation to be at 4.6 percent throughout 2023.

The data points will likely have a significant impact on the Federal Reserve’s policy regarding interest rates. On Wednesday, notes from the Federal Open Market Committee (FOMC) March meeting were made available to the public. During that meeting, the federal funds rate was raised by 25 basis points to roughly 5 percent.

However, according to the FOMC minutes release, there were discussions about a potential rate hike of 50 basis points. These talks were ultimately shelved because of issues with Silicon Valley Bank (SVB) and Credit Suisse. According to the FOMC minutes, it is believed that issues within the banking sector will result in increased lending standards that will likely have disinflationary consequences.

By Friday, the S&P 500 reached a high of 4,161, which represented a gain of about 1 percent for the week. The Dow reached a high of 34,023 on Thursday and finished the week up roughly 1.2 percent. Finally, the NASDAQ was up about .9 percent for the week after hitting a high of 12,191 on Friday morning. This year the NASDAQ has now gained 16.72 percent, the Dow is up 2.26 percent and the S&P 500 has increased 8.2 percent.

Those who own shares in bank stocks were among the biggest winners this week as JPMorgan Chase saw its share price rise by almost 7 percent on Friday to $138.03 a share. In addition, Citigroup shares experienced a rise of more than 4 percent Friday to $49.49. World Wrestling Entertainment (WWE) saw its share price go up by 2.3 percent to over $103 this week and has risen by more than 20 percent since April 2. That was the day that the company announced that it would be acquired by Endeavor, which is the parent company of the Ultimate Fighting Championship (UFC).

Fund Spotlight: Vanguard Extended Duration (EDV)

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In 2022, long-term U.S. Treasury bonds suffered their worst performance since the early days of the American republic. Rising inflation, along with Federal Reserve rate increases, sent bond prices tumbling. This wasn’t the start of the move though. Bonds peaked during the March 2020 lockdowns and had been falling steadily since then. It’s likely that last year’s low will hold for some time. As long as inflation is brought under control, interest rates on corporate bonds already compensate investors well for inflation risk. If inflation falls further, government bonds are also compelling options for fixed income investors.

The most volatile part of the government bond market is long-term Treasury bonds. In the U.S., that is the 30-year bond. These bonds fluctuate greatly when interest rates make large moves up or down because they are valued on 30 years’ worth of cash flows along with the return of principal. The most volatile security is the zero-coupon bond because all the cash flow comes 30 years from now. Any change in the interest rate is compounded for 30 years.

EDV is a zero-coupon bond fund that owns Treasury STRIPS with maturities of 20 to 30 years. This gives it one of the longest durations in the market at 24.23 years.

Duration is a measure of interest rate risk. Most investors are familiar with the concept of a bond’s maturity. That’s how many years it has until it matures and the principal is repaid. Bonds with high coupons, such as high-yield bonds, have durations lower than their maturity. In the case of zero-coupon bonds, they have durations that match their maturity.

A rule of thumb says that a bond or bond fund’s price will move about 1 percent multiplied by the duration, for a 1 percent move in the interest rate. Last year, both the 20-year and 30-year Treasury bond climbed about 2 percentage points. This would make for a possible 48 percent move in the price of EDV. In fact, the fund fell 39.16 percent, a bit better than expected.

Since the end of 2022, the 30-year Treasury yield has fallen about 0.3 percentage points. Multiply change in yield by EDV’s duration of 24.23 years and we get a number close to the 8.50 percent gain in EDV in 2023.

Reward-Free Risk

During periods of quantitative easing, the Federal Reserve cut interest rates to zero and held them there. At that time, some financial analysts and commentators referred to long-term Treasury bonds as “return-free risk,” a play on the term “risk-free rate” which refers to the 3-month Treasury bill rate. They called long-term bonds “return-free risk” because at the depth of the 2020 panic, 30-year Treasury bonds yielded less than 1 percent. Assuming interest rates would not go negative, there was almost zero upside in owning 30-year bonds even before considering future inflation. Their warning was prescient because between EDV’s all-time high in March 2020 and the low in October 2022, it would lose 55 percent of its value.

Today, the picture has changed. The Federal Reserve is still raising interest rates, but we’ve started seeing strain in the financial system. The failure of SVB Financial destroyed tens and perhaps hundreds of billions in capital, along with the tens of billions in stock market capitalization. This is deflationary and will help depress the rate of inflation moving forward. If more banks come under stress, the Federal Reserve will not continue its rate hiking policies. In short, we’re very close to the peak interest rate for this cycle.

Bonds Versus Stocks

During the era of quantitative easing, many bonds offered little in the way of income. Since the return on bonds was depressed, investors switched into high-yield debt for income or stocks in pursuit of capital gains. For much of this period, stocks were “cheap” relative to bonds because the latter offered so little in the way of return. In 2022, that started changing. In 2023, the yield on investment grade corporate bonds exceeded that of the S&P 500’s earnings yield (the inverse of the price-to-earnings ratio).

Comparing the S&P 500 earnings yield with investment grade corporate bond yield is a simple way to determine if stocks are over- or undervalued versus bonds. At current rates and stock valuations, investment grade corporate bonds are cheaper. However, this ignores that stocks are riskier on the whole. Stocks should trade at a discount to bonds because stock prices fluctuate more than bond prices. An investor who buys a bond and holds it to maturity is guaranteed the nominal return.

When investment grade corporate bonds offer a better yield than that of the S&P 500 Index, stocks are quite overvalued according to this measure. To wit, the last time corporate bonds had a higher yield than the S&P 500 earnings yield was in the late 1990s and 2007, both periods of stock overvaluation. However, in both cases this result was caused by extreme overvaluation of stocks and, naturally, bear markets ensued.

Given what we’ve seen in financial markets over the past month with increasing stress in the banking sector, it appears that long-term interest rates have peaked for this cycle. If long-term interest rates have peaked, long-term government bonds offer a compelling opportunity.

The likelihood of large losses in bonds is lower than it was at any time in the prior three years. In some scenarios where bonds lose big, stocks could lose more, meaning investors with growth and tech exposure are already taking on this risk. There are also scenarios where bonds win and stocks lose. All in all, there is a compelling argument for holding a fund such as EDV in place of some equity exposure, particularly in place of aggressive growth or technology stocks.

Vanguard Extended Duration

EDV tracks the Bloomberg U.S. Treasury STRIPS 20-30 Year Equal Par Bond Index. It currently holds 80 bonds. The average duration is 24.2 years, and the average maturity is 24.7 years. The expense ratio is 0.06 percent. The 30-day SEC yield is 3.99 percent.

EDV has 1-, 3-, 5-, 10- and 15-year annualized returns of negative 29.36 percent, negative 18.74 percent, negative 1.46 percent, positive 1.55 percent and positive 4.58 percent, respectively.

EDV has a standard deviation of 19.32. For comparison, the S&P 500 Index has a standard deviation of 20.74, making EDV almost as volatile as the stock market.

Outlook

Bonds are finally offering investors a compelling value proposition following last year’s sell-off. For the first time in years, investors can take on less credit risk and obtain meaningful income from investment grade corporate bonds and U.S. Treasuries. Longer-duration funds such as EDV also offer a better risk-reward proposition compared with growth stocks such as the Nasdaq or technology indexes.

This is even more pertinent if investors worry about recession risk and further downside in stocks, or if they believe long-term interest rates have peaked. A fund such as EDV can replace some of the tech or growth exposure in a portfolio, offering investors potential upside in scenarios where interest rates tumble in response to a recession or bear market in stocks.

EDV is not as compelling a holding within a portfolio’s bond sleeve because it is highly volatile and does have downside volatility risk. The income from EDV is not worth the risk when there are far less risky bond funds offering similar and, in many cases, higher yields. Investors would increase their overall portfolio volatility and risk if they swapped lower-risk, shorter-term bonds for a fund such as EDV. Compared with a fund such as Vanguard Information Technology (VGT) however, EDV doesn’t add that much risk and offers a different matrix of performance outcomes than do stocks.

In conclusion, for investors worried about recession and falling equity prices, and who believe long-term interest rates may have peaked, long-term bonds offer diversification. Long-term government bonds can rally if inflation falls, and they can rally if there is a bear market or recession that depresses interest rates. They might lag stocks in some of the “Goldilocks” scenarios, but when considering both the potential upside and downside of the technology and growth sectors of the market, a small allocation to EDV within a portfolio’s equity allocation can provide a measure of diversification without the kind of downside risk that such a position would have had for much of the previous decade.

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