The Bloomberg Barclays U.S. Aggregate Bond Index, the flagship index for assessing the overall U.S. bond market (think of it as the S&P 500 for bonds), is having one of its worst starts for a calendar year in its history (which dates back to 1976). Indeed, the return through 3/12/2021 is on track to be the second worst performance for the first quarter of a year, only behind 1980.
First Quarter Returns for the Bloomberg Barclays U.S. Aggregate Bond Index (worse to best)
The reason for the lackluster performance so far this year has been the rise in interest rates. Interest rates have risen due to faster economic growth and fears of increased inflation that could stem from that stronger growth. Bond Prices have an inverse relationship to interest rates. That is, when interest rates go up, the prices of bonds fall, and vice-versa. This negative correlation between interest rates and bond prices may seem somewhat illogical, but can make more sense upon closer examination:
- Most bonds pay a fixed interest rate that becomes more attractive if interest rates fall, driving up demand and the price of the bond. As interest rates rise and fall, the fixed stream of income (yield) offered by bonds that are already traded freely in the market place will become more or less attractive relative to newly issued bonds. As rates fall, if the bond that is already traded in the market has a larger stream of cash flow than a newly issued bond, the older bond will appreciate as its cash flows will be more attractive, pushing its price higher and its yield lower. The opposite occurs if rates rise, bonds already trading will fall in price to compete with newly issued bonds with higher income streams. This search for equilibrium plays out each and every day as economic and inflation assumptions change perceptions of where future bond yields will need to settle.
One of the most tracked interest rates in the world is the U.S. Treasury 10-year yield. The yield on this index was hovering between 0.50% – 0.60% for much of last year but began climbing in August. It has accelerated in 2021 from a start of 0.91% to around 1.5%, a rapid and large increase, almost tripling off the low of last year.
Again, a rise in interest rates is bad for bond prices, hence many types of bonds have suffered across the spectrum as rates rise:
Needless to say, the start of the year has been difficult for bond investors. Furthermore, the rise in rates has been met with a fervor that may signal the end of the long enduring bull market in bonds. This bull market began when former Fed Chairman Paul Volker broke the back of inflation in the early 1980s, which resulted in interest rates coming down consistently over the next forty years. The chart below shows the monthly rate on the U.S. 10-Year Treasury from 1962 to February 2021. The current rise in rates is not a new phenomenon, during this larger trend of declining rates, there have been bouts of rates rising, only to continue on their downward trajectory. Only time will tell if this is indeed the beginning of a longer trajectory for rising rates, instead of a pit stop.
Higher Rates = A Negative Feedthrough for Growth Stocks
The spike in bond yields has spooked growth stocks. Some of these stocks are companies such as Apple, Amazon, Facebook, Microsoft, Google, etc. These stocks also happen to make up the largest portions of several stock market index weightings, which is why we have seen big drawdowns in indices such as the NASDAQ over the last couple of weeks. The reason that growth stocks are being sold off is that they have high P/E (price/earnings) ratios and those high P/E ratios can be more sensitive to increases in interest rates than low P/E stocks. Stocks that have a high valuation compared to their actual earnings must justify this high valuation with large amounts of future earnings (i.e. grow their earnings substantially). Due to inflation, dollars earned in the future are worth less than dollars earned today, and a rise in interest rates is partly driven by a rise in inflation expectations. All else equal, higher inflation means future dollars (i.e. earnings) are worth less today then if inflation was lower.
The S&P 500 and NASDAQ 100 have become heavily weighted in growth stocks due to the success of these tech-oriented companies. As the stocks have gone up, they become a bigger percentage of each index and therefore impact the way the index moves on any given day. Much of this will settle as time passes. The sell-off in yields has also been quite pronounced in long U.S. Government Treasury bonds and those bonds have reached an oversold level that is now quite extreme, as shown in the graph below. The Relative Strength Index (RSI) is a signal that attempts to measure the overbought or oversold nature of a security’s price movement. We can utilize the Bloomberg Barclay US Long Government Float-Adjusted Bond Index as a proxy for long Treasury bonds. Below is the monthly RSI of the index, a drop below 50 indicates these bonds may be significantly oversold.
As can be seen by the tables below, the markets have been able to digest spikes in rates before this current episode and recover. The tables show what happened in terms of forward returns every time the monthly RSI for these long Treasury bonds fell below 50. Forward returns are for the S&P 500, NASDAQ 100, the proxy index we used for long Treasury bonds, and a 60/40 portfolio of the S&P 500 and the long Treasury bonds.
While most investors view bonds as relatively safe in comparison to stocks, accurate as that may be, they are not entirely risk-free investments. Given the much lower frequency of bond market declines compared to the stock market, it occasionally catches investors off guard when bonds do experience a decline. Leaning on history, we can see that the overall bond market tends to recover in time, and indeed most years finishes positive. Of the 44 years calendar years we have data for the Bloomberg Barclays U.S. Aggregate Bond Index, 41 (93%) finished positive. Not including 2021, 12 calendar years posted a negative performance in the first quarter of the year, of which 9 (75%) went on to finish with a positive return for the year.
Using the Bloomberg Barclays US Long Government Float-Adjusted Bond Index as our proxy for long-maturity Treasury bonds, returns were positive 32 (73%) out of 44 calendar years. While these bonds do experience more volatility (ups and downs) relative to the overall bond market, they have historically benefited investors with a higher average return then the overall bond market. The average calendar year return for these longer maturity treasury bonds has been 9.20% versus 7.32% for the overall bond market index.
We think that rates are going up for the right reasons – economic growth. Stocks have historically not been knocked off course by rising rates and we do not believe this time will be any different.
General Disclosures: The content contained in this article represents the opinions and viewpoints of Cardan Capital Partners only. It is meant for educational purposes and not meant for consumer trading decisions. All expressions are as of its publishing date and are subject to change. There is no assurance that any of the trends mentioned will continue in the future. Market performance cannot be predicted, so nothing in our commentaries is ever meant to provide any kind of trading advice or guarantee of future results. Certain information contained herein has been obtained from third party sources and, although believed to be reliable, has not been independently verified and its accuracy or completeness cannot be guaranteed. Any reproduction or distribution of this presentation, as a whole or in part, or the disclosure of the contents thereof, without the prior consent of Cardan Capital Partners, LLC, is prohibited. Investments in securities entail risk and are not suitable for all investors. This is not a recommendation nor an offer to sell (or solicitation of an offer to buy) securities in the United States or in any other jurisdiction.