Why are bonds, bond ETFs and bond funds falling in value?

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Bonds, which were supposed to be a safe asset class suitable for risk-averse investors and retirees, proved in the first half of 2022 how wrong that assumption was. The S&P US Aggregate Bond Index, which measures the aggregate performance of publicly traded, high-quality US dollar-denominated debt, fell 10% as of June 24, its highest level since its inception.

The rout in bond prices was triggered by the decline in Asian high-yield bond funds in 2021, which were initially affected by the risk of default by property companies in China, such as China Evergrande. It quickly spread to emerging market sovereign bonds. This year, even high-quality bond funds have fallen significantly in value when they were expected to hold their value given the volatility in equity markets.

This can be a concern for investors who are heavily biased towards bond investments or who invest in a diversified portfolio.

Major bond indices are down as 10-year US Treasury yields rise

S&P US Aggregate Bond Index

The S&P US Aggregate Bond Index, which measures the aggregate performance of listed, publicly traded US dollar-denominated investment-grade debt, was down 10% from the start of the year to June 24, 2020.

ABF Singapore Bond Index Fund

The ABF Singapore Bond Index Fund, which closely matches the total return of the iBoxx ABF Singapore Bond Index, currently tracks the returns of Singapore dollar-denominated bonds issued by the Singapore government and quasi-Singaporean government entities. This ETF is down 8% year-to-date through June 24, 2022 despite its high-quality bond holdings.

10-year US Treasury yield

The 10-year Treasury yield is the yield that the US government pays investors to buy its securities. This represents the risk-free rate for investors when deciding to invest in stocks and other riskier securities. The yield on Treasury bills rose from 1.63% at the start of the year to an 11-year high above 3% on June 24. Moreover, the 40-year downtrend may soon reverse with an upward trend in interest rates.

What drives bond prices down?

Bonds are debt securities issued by companies and governments for the purpose of raising capital in the primary market. These bonds, whose maturities and coupon rates vary, can also be traded on the secondary market. This allows the investor to realize the investment in the bond before its maturity.

Usually, bonds in the secondary market are less volatile than stock prices. This makes them ideal for investors seeking capital preservation and stable cash flow. However, that’s not to say that the value of these bonds wouldn’t decline or appreciate like stocks.

Bond price volatility can normally be attributed to the following three reasons.

Reason 1: Creditworthiness of the borrower

Bond prices can fluctuate based on a sudden change in a borrower’s creditworthiness.

When a borrower faces a business in operation and is unable to pay the principal amount or misses a coupon payment, this would be considered a default. In such a scenario, current lenders would be willing to discount their bonds in order to realize their investment. Similarly, new bond investors would also be less willing to pay face value and demand a lower price depending on the risk of default. Both scenarios would lead to lower bond prices.

On the other hand, assuming a stable interest environment, investors might even be willing to pay more than face value for bonds issued by high-quality or financially strong issuers, such as the Singapore government or quasi-corporations. -governments like Temasek. The higher premium reflects the lower default risk of these bond issuers relative to their coupon rate.

Also Read: Complete Guide to Investing in Corporate Bonds in Singapore

Reason 2: A change in interest rates

A change in interest rates will affect bond prices.

When interest rates rise, bond prices fall. Yields and bond prices have an inverse relationship.

For example, suppose you were to purchase a bond at face value of $100 for an annual coupon payment of 5%. If the interest rate rose to 6%, your bond that issues a 5% coupon would no longer be worth the same $100, because investors could buy other bonds that issue a 6% coupon for the same $100. Therefore, your bond would lose value to adjust for the lower yield to attract buyers.

Similarly, if the interest rate fell to 4%, the value of your bond would increase to reflect the higher yield your bond is offering in a lower interest rate environment.

In both scenarios, assuming the bond issuer continues to pay the fixed coupon regardless of the external interest rate environment, the investor (lender) will suffer no loss if held until at the due date. There would, however, be an opportunity cost in a rising interest rate environment, as the lender could obtain higher yielding bonds for the same investment.

Also read: Astrea 7 Bonds: 10 things investors need to know about this private equity bond (offering up to 4.125% and 6.0% interest)

Reason 3: High inflation

Inflation has increased in recent months in many countries. And particularly in Singapore, underlying inflation reached 3.6% in May, a 13-year high.

Inflation reduces the purchasing power of all assets, especially cash and bonds. Coupon payments and principal amount will buy less than if there were no inflation.

When inflation is high and bond yields are low, the real return (adjusted for inflation) can be negative. Currently, real yields are -5%, based on 10-year US Treasury rates.

Source: FRED Economic Data

What is causing bond prices to fall in 2022?

To prop up its COVID-19-ravaged economy, the Federal Reserve (Fed) has engaged in unlimited quantitative easing by buying $120 billion in bonds per month. It consisted of $80 billion in US Treasury securities and $40 billion in mortgage-backed securities and ran until December 2021, when it ended.

The ‘easy money’ policy helped the US economy rebound from a recession, but also led the consumer price index (CPI) to rise 7% in 2021, the biggest change cost of living since 1981. The Fed must begin quantitative tightening to curb rising inflation. However, the escalation between Russia and Ukraine, two major commodity exporters, has accelerated rising inflation as energy and food prices spike due to supply chain disruptions. .

As a result, the Fed has raised interest rates three times this year, signaling a more hawkish stance in 2022. The latest hike announcement in June 2022, of 0.75%, marked the largest increase since 1994. With the US CPI hitting a new high of 8.6% in May, the Fed is expected to raise interest rates a few more times this year to halt rising inflation.

Given its inverse relationship, bond prices could continue to be negatively affected in a rising interest rate environment.

Also Read: How You Can Trade Big Bonds Like Stocks

Are bonds still a safe asset class?

Bonds can seem like a risky asset class, especially in the current economic climate of rising inflation and rising interest rates. However, bonds are still not as risky as stocks based on past data. The charts below, which show quarterly stock returns since 1976, indicate that stocks have more and larger negative quarterly returns than bonds.

Source: S&P 500 Quarterly Returns, 1976 through March 31, 2022. Data from Dimensional Fund Advisors.

Source: US Aggregate Bond Index, quarterly returns from 1976 to March 31, 2022. Data from Dimensional Fund Advisors.

Also read: How fixed income ETFs can help protect your investment portfolio in Singapore

How to position your bond investments in 2022?

Each asset class, whether stocks, bonds, or otherwise, serves a function in an investor’s portfolio based on their risk tolerance and investment goals.

Similarly, bond investors facing paper losses due to falling bond prices could continue to hold the bonds (i.e. individual corporate bonds or bond funds) and receive the coupon payments, provided the underlying issuer is financially sound and has no going concern. . Even though bond funds may reflect lower prices, income received from the funds will continue to grow with higher returns from the fund’s new bond investments.

Additionally, investors who prefer to stick to bond investments might choose short-term bonds (1-3 years) as they are less sensitive to changes in interest rates and can also help mitigate price sensitivity in a portfolio if interest rates continue to fall. ascend.

Finally, investors could also choose to invest in Singapore Savings Bonds (SSB) as they have no reinvestment risk. SSBs, which are backed by the Singapore government, have no prepayment penalty charge, allowing you to buy higher-yielding bonds if interest rates continue to rise.

Also Read: 20 Investment Platforms Singaporeans Can Use to Invest a Fixed Monthly Sum

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