Over most of the past two years, bonds have struggled to serve as a complementary diversifier to the risk of owning stocks. Historically, bonds have performed this duty quite well. However, with the Federal Reserve raising interest rates so dramatically, and so quickly, bonds have been caught in the crossfire and were quite volatile in 2022 and 2023. As longer-term interest rates fell in the fourth quarter of 2023, bonds staged a rally. Looking forward to 2024, bonds are positioned well to perform well under various market conditions. We present here some background on bond investing before sharing our views on the landscape ahead.
Background on Bonds
A bond is an agreement for an investor to loan money to an entity (government, corporation, etc.) with the expectation that they will receive their principal back at a future date, along with periodic interest payments. Bonds can be held to maturity, or sold at any time like a stock. Of course, the value of a sale prior to maturity may be less, more, or the same as one would get by holding the bond to the maturity date.
Because of the expectation that your principal will be returned, bonds function differently than stocks. Bonds come in many different styles: federal government bonds, corporate bonds, international bonds, bonds with various lengths to maturity, high credit risk bonds, municipal bonds – the flavors are numerous! However, the various bond types share some common characteristics and risk factors, some of which are significantly different from stocks. The methods of investing in bonds are the same as stocks – either by owning individual securities or by pooling money with other investors in the form of mutual funds or exchange traded funds.
What are the risks?
Bonds are most affected by two factors: fluctuations in interest rates and inflation. While the Federal Reserve directly sets short-term rates, the broader market generally sets longer rates based on expectations for economic growth and inflation. Prices of existing bonds and interest rates move in opposite directions, which is why bond performance has struggled at times over the past two years as the Fed has substantially raised rates. Elevated inflation eats away at the purchasing power of interest payments, which remain constant throughout the term of the bond. Elevated inflation in the recent past has also hampered performance of bonds.
In addition to interest rate risk and inflation risk, credit risk is another vital consideration. Different types of bonds have different levels of credit risk. U.S. Treasury and agency bonds have extraordinary minimal risk of default, while all other types (e.g. corporate, municipal, asset-backed, international) have varying levels of credit risk – depending on the characteristics of that particular issuer. Based on the credit-worthiness of the issuer, bonds are typically classified into two main categories: investment grade and high yield. Investment grade typically are higher rated companies and governments (and pay a relatively lower interest rate), while high yield bonds come from lower-quality issuers and have to pay a higher interest rate to compensate investors for the larger default risk.
Returns: A Brief History
Total return for bonds is made up of both interest payments and capital fluctuations. For a bond purchased at face value and held to maturity, the return is simply determined by the interest payments. However, since bonds can be bought and sold at any time, the difference between purchase and sale price can result in positive or negative movements, either enhanced or offset by interest payments.
The below chart demonstrates the unusual performance of bonds during 2022 and early 2023 as the Fed raised rates dramatically. However, performance over the last quarter of 2023 erased losses from earlier in the year.
What should we anticipate for 2024?
Why might bonds seemingly have a clearer path to positive returns in 2024? The combination of higher current interest payments than have been available since the 2008 financial crisis, the potential for capital appreciation if rates decline, and the potential increase in demand for bonds if stocks correct lower all point to a positive 2024 for bonds in most of the likely economic environments.
Planning Alternatives offers many ways to invest in bonds – from U.S. Treasuries to diversified mutual funds to separately managed portfolios of individual securities. Please contact your advisory team to determine what the best approach is for you.