Bonds Have Had a Terrible Year (and that is what makes them attractive)
There is no question that bonds have had a terrible year. How terrible? The Bloomberg Aggregate Bond Index has fallen over 10% year-to-date through July. To put that move into perspective, the Bloomberg Aggregate Bond Index has been positive for 38 out of the last 42 years, and the largest drop during that time-period was -2.94% in 1994. This year’s steep rise in interest rates has caused a steep drop in bond prices. As a benchmark, the 10-year Treasury yield, a widely watched measure of prevailing interest rates, moved from 1.51% on December 31st of 2021 to 2.92% on Friday, almost doubling. Of course, this move in interest rates is what now makes bonds increasingly attractive.
Bond prices are well known to move inversely to interest rates. The relationship can be explained through a quick example. If the owner of a bond paying 5% interest would like to sell that bond and the prevailing interest rates have now moved to 6%, then the bond owner must sell the bond at a discount to attract buyers who could find a 6% yield elsewhere. Therefore, bond prices fall as interest rates rise. What is often lost in this analysis however is that bond investors are rewarded with a 6% yield going forward. As a result, rising interest rates can be bittersweet to bond investors, who face declining near-term prices, but higher longer term interest income.
This fundamental relationship between interest rates and bond price explains why bonds have had a terrible year so far. The rise in interest rates has driven bond prices lower. However, the rise in interest rates also make bonds a far more attractive investment going forward. Bond investors have suffered for years with dismal rates, but now are seeing rates that are much more reasonable. For example, Investment grade corporate bonds now yield an average of 4.83%, and high-yield bonds, which expose the buyer to greater credit risk, now average 8.12%.
Similarly, the bond positions in our portfolios have risen to much more attractive yields. For example, Pimco Income and Rivernorth Doubleline, two of our core bond positions, now yield 5.27% and 9.35% respectively. With the economy slowing, the ability to generate these types of interest rate yields is an attractive component of a diversified portfolio.