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 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.
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.
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.
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.
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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