You Might Learn To Love The World’s Most Hated Investment

You Might Learn To Love The World’s Most Hated Investment
Stéphane Renevier, CFA

almost 2 years ago4 mins

  • Bonds have gone through their worst period ever, with losses for US government bonds reaching record levels.

  • But interest rates are rising, and bonds are well placed to benefit as the narrative shifts from “high inflation” to “low growth”.

  • What’s more, bonds should once again be a good hedge against losses in your risky assets if the economy sours.

Bonds have gone through their worst period ever, with losses for US government bonds reaching record levels.

But interest rates are rising, and bonds are well placed to benefit as the narrative shifts from “high inflation” to “low growth”.

What’s more, bonds should once again be a good hedge against losses in your risky assets if the economy sours.

With inflation at levels last seen in the 1970s and the Fed embarking on one of its most aggressive rate-hike cycles ever, it’s no surprise that bonds are currently the world’s most hated asset. But when you see everyone and grandma bearish on one particular asset, you’re probably onto an interesting contrarian trade. And indeed you are.

Why have bonds fallen out of favor?

Inflation hasn’t been this hot since the 1970s, and it’s forced the Federal Reserve (the Fed) to hike interest rates a lot more quickly than investors anticipated.

Both rising interest rates and high inflation are bad for bonds: high inflation reduces the purchasing power of the bond’s cash flows, while higher rates force existing bonds to trade for less than higher-yielding new bonds. That’s bad for all bonds, but particularly for longer-term US Treasuries, which are more sensitive to interest rate and inflation changes than shorter-term ones.

20+ years treasury bonds showing record losses. Source: Koyfin.com
20+ years treasury bonds showing record losses. Source: Koyfin.com

Why shouldn’t you listen to the naysayers?

When everyone’s bearish on something – and when that “something” has already lost a record amount of money – you should ask yourself whether they’re right to be so negative.

Because somewhat counterintuitively, assets are actually less risky when they’re experiencing their largest losses than when they’ve been steadily going up for years. And just like buying stocks was a better idea in 2009 than it was in 2008, buying bonds is arguably a better idea today than it was a year or two ago, when interest rates were still low and falling.

Now don’t get me wrong, there’s still a good chance that interest rates and even inflation will rise. And if that happens, sure, you’re unlikely to make money buying bonds, even at these levels. But successful investing is as much about asymmetries in risk and reward as it is how often you’re right. And at current levels, the risk-reward of adding bonds to your portfolio seems pretty attractive.

Why is the risk-reward looking so tasty?

Higher yields will drive higher demand

You heard that right: the main reason bonds are crashing – rising interest rates – is the same reason you might want to invest in them.

While rising rates will translate into big losses for investors in existing bonds, they’ll offer investors in new bonds a higher return. From that perspective, the higher the interest rate, the better. At these higher rates, demand for bonds should come surging back. After all, when you can pocket a virtually risk-free 3% by investing in US Treasury bonds, investors will be much less incentivized to invest in risky assets like stocks – particularly if the outlook for the economy looks challenging.

The bond market is ripe for positive surprises

Bond prices already reflect the more challenging outlook of higher interest rates and inflation. That much is clear from the record losses in bond prices.

And now that prices are so low, any positive surprises regarding either interest rates or inflation could lead bond prices to recover sharply. In fact, that’s what happened in 2019, when the Fed U-turned on its rate hikes after it became evident that the economy wouldn’t be able to handle higher rates. On the flip side, it would take some pretty bad news for prices to fall further, given how unpopular the asset already is.

The recession risk will soon outweigh the inflation risk

The market’s main focus at the moment is inflation, and the Fed’s number one priority is to fix it. That’s obviously not good for bonds.

But the Fed is actively intending to slow down growth to reduce inflation. And if history is anything to go by, it’ll overshoot the mark: the Fed has only ever managed to achieve a “soft landing” – when it didn’t tip the economy into a recession – on one occasion in history. Fed chairman Jerome Powell certainly doesn’t sound too confident this time around, saying recently that a “soft-ish” landing was more likely. And when the Federal Reserve finds itself confronted with a US economy in recession, it won’t have much choice: it’ll have to slash interest rates yet again.

So what’s the opportunity here?

Even if the risk-reward profile doesn’t persuade you to buy bonds, you might still want to consider adding them to your portfolio for their diversification benefits.

While real estate, commodities and stocks would show diversification benefits when the economy’s performing well, they’re all likely to fall if it dips and sentiment turns. In that environment, only safe-haven assets like gold and US Treasuries are likely to offset your losses. But bonds should benefit more than gold if inflation drops off along with economic growth. That arguably makes US Treasuries the best hedge at these levels.

Both the iShares 7-10 Year Treasury Bond ETF (ticker: IEF, expense ratio: 0.15%) and the iShares 20+ Year Treasury Bond ETF (ticker: TLT, expense ratio: 0.15%) are solid options if you’re looking to buy bonds. But I’d personally go with the latter: it’s more sensitive to economic growth and inflation, which should give you more bang for your buck in this environment. And remember you don’t need to buy it all at once: entering gradually over time – as prices fall – might be a great way of smoothing your entry point.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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