The Investor Guide to Fidelity Funds for April 2023 is AVAILABLE NOW! April Data Files Are Posted Below Market Perspective: Tech Stocks Rally as Government Bails out Banks The Nasdaq surged […]
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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The week leading up to Good Friday and Easter got off to a quick start as the Institute for Supply Management (ISM) released its March Manufacturing PMI number. The final result was 46.3, which was below the forecast of 47.7 and was the fifth straight month in which the PMI number was below 50.
This indicates a contraction within the manufacturing sector that may be a precursor to a larger economic slowdown. It may also be a sign that the Federal Reserve may have to rethink future interest rate hikes. The federal funds rate currently sits at 5 percent after it was raised by 25 basis points in March. Federal Reserve Chairman Jerome Powell has indicated that additional increases may be warranted but that they would be dependent on future data.
On Tuesday, the Job Openings and Labor Turnover Survey (JOLTS) was released. It found that there were 9.93 million available positions in the United States, which was the lowest since the 9.21 million recorded in July 2021. Analysts had expected the March figure to be closer to 10.49 million prior to the survey’s release.
Wednesday saw the release of important reports both before and after the trading day began in New York. At 8:15 a.m., the ADP Nonfarm Employment Change report was released and declared that 145,000 jobs were lost between February and March. Prior to release, it was believed that the report would show a gain of 208,000 jobs. At 10 a.m., the ISM Services PMI was released and came in at 51.2 percent, which was lower than the forecast estimate of 54.3 percent.
The news did provide some opportunities for traders looking to buy dips or to make short-term trades. On Monday, the S&P broke the 4,100 level, which was a yearly high, and the market continued higher on Tuesday before reversing and settling into a trading range between 4075 and 4115 for most of Wednesday and Thursday. For the week, the index lost 0.1 percent, lowering the yearly gain to 6.9 percent.
The Dow spent most of the week between 33,000 and 33,500, which is a retest of a high set in March. For the week the Dow gained 0.6 percent and has now gained 1.0 percent gain in 2023.
The NASDAQ peaked at 13,192 on Tuesday before easing back to 13,086 at the close of trading on Thursday. This index has gained over 15 percent in 2023, despite dropping 1 percent on the week.
Gold spent the first three days of the week making significant gains as it surged from the 1950 level to 2025 by Wednesday. This represents the high of the year and a break of a high set in February. Although gold prices fell slightly on Thursday, they are still hovering close to $2,000 an ounce. An increase in gold prices combined with a contraction in the manufacturing and services sectors may be a sign that investors are trying to hedge against near-term uncertainty.
Oil prices quickly climbed above $80 a barrel on Monday before trading mostly sideways on Tuesday, Wednesday and Thursday. This represents a break above the March high and puts the commodity in position to threaten yearly highs going into the holiday weekend. Exxon stock jumped from $109.44 at the close of trading on March 31 to $114.92 upon the opening bell Monday morning. It would then peak at $117.18 during Monday’s session before dropping 2 percent on Thursday to close at $115.06.
The CBOE Market Volatility Index (VIX) stayed in a tight range for most of the week as traders were not keen to make major moves in anticipation of Friday’s Nonfarm Payroll report issued by the Bureau of Labor Statistics (BLS). That report showed that the economy gained 236,000 jobs in March, and the unemployment rate dropped from 3.6 percent to 3.5 percent. Average hourly earnings went up .3 percent during that period, which beat the forecast of .2 percent.
For years, bond and fixed-income investing were simplified by the Federal Reserve’s zero interest rate policy. Many bonds offered zero or near zero interest. Bank CDs weren’t much better. After a brutal 2022, many parts of the bond market reset the table. Bonds became a great way to achieve income investing goals again, with yields climbing past 4 percent on short- and long-term government bonds.
Most bonds pay fixed coupons, the same amount and usually twice a year. When interest rates rise, the price of an existing bond will fall because investors can buy new bonds with higher yields. When interest rates fall, the bonds go up in price because new bonds offer less income. Investors holding bonds to maturity don’t worry as much about changes in interest rates, but those investing in bond funds will see the fund value rise and fall in the opposite direction of interest rates.
There are two main risks with bonds: interest rate risk and credit risk. U.S. Treasurys have no risk of default because the government can print money to pay principal and interest. The price of Treasury bonds moves entirely based on the interest rates. If the market pushes rates up, Treasurys sell off. If the market pushes rates down, Treasurys rally. Corporate bonds also move based on interest rates, but their price change isn’t solely determined by changes in interest rates.
Investors can quickly access the interest rate risk of a bond by looking at the duration, a statistic found on nearly all financial websites. The rule of thumb is that for every 1 percent change in the relevant interest rate, the price of the bond or fund will move by the duration. If a fund has a duration of 5 and interest rates rise/fall one percentage point, the fund will decrease/increase about 5 percent.
Credit risk also factors into bonds of companies and countries that don’t issue debt in their own currency. The higher the credit risk, the more the price of the bond will be driven by credit risk rather than interest rate risk. In the past decade, the only way to obtain significant income from a bond portfolio was through higher-yielding bonds. For the first time since before the 2008 financial crisis, these bonds finally have some competition.
Conservative Short-Term Bonds
It has been more than a decade since investors could expect a nice return in a money market fund, but those times are back. Fidelity Government Money Market (SPAXX) has a 7-day SEC yield of 3.96 percent. Since the Federal Reserve isn’t done hiking, it’s almost guaranteed to rise to around 4.25 percent in the next month and then possibly toward 5 percent or more later this year if the Fed keeps hiking. This income is “risk free” since it comes from U.S. government securities.
Investors can achieve slightly higher yields with short-term bond funds such as Fidelity Short-Term Treasury Bond Index (FUMBX), which yields 4.10 percent.
The risk with these funds isn’t loss of principal; instead, it is the potential loss of income if bond yields fall. Investors will not receive much “compensation” via capital gains as yields fall.
These funds are best suited for two environments. First, when interest rates are stable, they can produce reliable income over long periods of time. Second, when interest rates are rising, they mitigate losses. In 2022, SPAXX gained 1.31 percent. Even though it has a low duration, the rapid rise in rates sank FUMBX by nearly 7 percent.
Investors who do not expect any rate cuts and want to capture rising rates with no risk can stick with a money market fund such as SPAXX. Investors who think rates might peak later this year and who might hold the position into 2024 when the possibility of rate cuts will increase, have more potential upside from FUMBX while collecting a similar level of income today.
Diversified Bond Funds
As long as interest rates are in a normal range, investors can profit from bond diversification. Exposure to Treasurys, corporate and high-yield bonds of varying maturities can produce good income and solid long-term returns. Diversified bond funds such as Fidelity Total Bond (FBND, FTBFX) currently yield 3.13 percent.
Total bond funds were down about 17 percent at their lows last year. Adjusted for dividends, these funds lost all their gains going back to 2015. It’s worth noting the bulk of the gains came in between 2019 and 2022 when the Federal Reserve was slashing interest rates to zero. If we remove dividends, the losses on the bond portfolios exceeded those of 2008. Stripped of dividends, the low for FTBFX in 2022 came within a few percentage points of the 2008 low.
One of the axioms of investing is “buy low, sell high.” While the process of making a low can be complex and take time, the price of commodities such as crude oil, wheat and natural gas all point to falling inflation later this year. The capital losses experienced by bonds in 2022 won’t be repeated this year or next. If the Federal Reserve stops raising rates later this year, the risk of capital losses will decline and be replaced by potential gains from falling rates.
Investors who want a little more income with less credit risk can opt for the far more narrowly invested Fidelity Intermediate Treasury Bond Index (FUAMX). It has a 30-day SEC yield of 3.57 percent and a duration of 6 years. The fund gained about 3 percent from October to February when the 10-year yield fell about one percentage point. This gives investors similar income without any of the credit risk contained in FTBFX.
Within the bond universe, broadly diversified funds will always deliver a return somewhere in the middle of the bond market. These funds are best for investors with very long holding periods who want to minimize the number of funds in their portfolio.
Long-Term Government Bonds Are an Aggressive Option
In prior years, investors referred to long-term government bonds as “return free risk.” Income was a pittance and did not compensate for the risk because bond yields couldn’t get much lower with the Federal Reserve at zero percent. Getting the lower bond yields seen in Japan and Europe would require the Federal Reserve to cut going into negative territory with interest rates. The risk in long-term bonds manifested itself in 2022. Long-term Treasury bond funds tracked the Nasdaq, with both asset classes losing more than 30 percent of their value.
With bond yields rising since then, long-term government bonds offer potential capital gains in the event of a recession and interest rate cuts. From the October low to the December high, the Fidelity Long-Term Treasury Bond Index (FNBGX) gained 16 percent. In February though, the fund gave back close to half those gains. This level of volatility is unsuitable for most investors. Additionally, the 3.75 percent yield offers no income advantage on money market and short-term bond funds but still contains substantial downside risk if inflation and interest rates do not peak this year or eventually go much higher.
That said, unlike in 2021 and 2022, long-term government bonds can potentially hedge a portfolio against recession and bear market risk if yields drop. If and when signs of recession appear, aggressive active investors may consider using long-term government bond funds as a hedge against that risk.
High-Yield Bonds Remain Attractive
High-yield bond funds are least attractive in a recession and most attractive in growing economies when credit risk is low. Talk of recession has picked up because the yield curve is inverted and inversions of this size have been followed by recessions in the past, but the timing of such a recession is unknown. At the moment, the Atlanta Federal Reserve’s GDPNow model has been hiking its growth forecast for the first quarter, hitting 2.8 percent as of February 27. The market has been reducing its assessment of credit risk since July. Spreads between higher-yield bonds and similar Treasurys have been falling since then.
Fidelity Floating Rate High Income (FFRHX) has a duration that approaches zero because the bonds in its portfolio reset as interest rates rise. FFRHX has a positive return since the end of 2021 because most of the bond market risk last year was centered on interest rate risk, not credit risk. It has an 8.55 percent 30-day yield, and that can go higher with Federal Reserve rate hikes.
Credit risk is the main worry for investors in this fund. The low in FFRHX came in July 2022 (the fund was down about 5 percent from its high at that point) because that is when credit risk peaked.
Floating-rate funds such as FFRHX only suffer if interest rates start falling, in which case the yield on these bonds will also.
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The March Issue of the ETF Investor Guide is AVAILABLE NOW! Links to the March Data Files have been posted below. Market Perspective: Bank Failures Put the Fed in a Bind […]
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