Here’s why the bond market scam

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Many thought bonds could be a safe haven amid a torrid 2022 for equities. However, a combination of risk factors caused the bond market to decline as well as other asset classes such as equities and real estate. I don’t know if bonds in general and US bonds in particular will rally soon; Here’s why.

Credit risk

Bond returns can essentially be tied to a few risk premia. The most important is credit risk, which refers to counterparty default or the risk of late payment.

The problem with credit risk today stems from the risk of recession. Yield curve inversion is usually associated with a sharp economic contraction, exacerbating counterparty risk.

Additionally, many investors in the bond market might anticipate excessive credit risk for bonds of specific maturities, causing a barbell rebalancing. Therefore, the market looks likely to segment and cause larger losses on short-term bonds.

Inflation risk

Inflation is another component of bond yields. Inflation risk premiums are generally divided into two components: the rate of inflation and inflation uncertainty.

It is well known now that inflation in the United States is exorbitant. Inflation dilutes the value of lenders’ assets. However, the real problem is monetary policy uncertainty, which leads to volatile inflation, which in turn leads to excessive inflation risk attached to the general bond market.

Inflation is likely to continue to impact the bond market unless a coherent long-term monetary policy plan is communicated to (and accepted by) the general public, but after four decades of increasingly accommodating, that seems unlikely.

What about TIPS?

TIPS are inflation-linked bonds that rise and fall in price with inflation rates. TIPS would be a good investment in a high inflation market with built-in growth. However, in the end, the risk of recession will outweigh the inflationary obligations.

Too many analysts think of inflation in a linear fashion. The nature of comparative inflationary periods is not always the same. Returning to the yield curve tells us that a bearish flattening is occurring, which means that long-term interest rates will likely rise more slowly than short-term rates, which could lead to stagflation. Thus, there is little evidence that TIPS will be a valid hedge against inflation.

Final Thoughts

The market clearly does not view bonds as risky assets at this time. The dominance of credit risk and inflation-related uncertainty is at the heart of the issues facing bond investors.

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Source: Portfolio Viewer

A stress test of Vanguard’s international bond ETF shows that bonds haven’t suffered so much at any time in the past decade. Have Bonds Bottomed or Are We Heading for a Credit Crunch? We will have to wait and see.

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