The largest bond correction in history is good news for the future
The labyrinthine world of bonds can be confusing for those who are not familiar with its functioning, but it offers important insights into the wider financial system. Over the past few years, bond yields have been on a truly tumultuous journey, with huge swings that have left even seasoned investors scratching their heads. This article sheds light on the wild story of bond yields in recent years.
Setting the Stage – Panic in March 2020
Our story begins in March 2020, when the pandemic pushed our world into an abyss of uncertainty. During these extraordinary times, something unprecedented happened in bonds. The yield on the 30-year bond fell below 1%, an all-time low.
This historic event was the result of widespread fears of deflation and the looming spectre of another 'Great Depression'. Fearing this, people around the world began to buy government bonds in a panic.
The United States followed the path of Europe and Japan, and investors began to anticipate that yields on US government borrowing could also fall into the negative territory.
Record low yields and massive demand for safety are deeply linked to lockdowns and complete shutdowns of economies around the world.
Note: Bond yields in May 2020
Change of Sentiment
After the pandemic was over, fears of deflation were quickly replaced by fears of inflation due to extreme government stimuli, a strong economy and consumption, the war in Ukraine, and disrupted supply chains. Inflation rates in advanced economies have reached double digits for the first time in more than four decades. The sharp rise in prices has required an equally aggressive response from central banks.
The world witnessed the steepest rise in interest rates in modern history, which, of course, could not leave sensitive bond markets lying idle. As a result of the radical tightening of central bank policy, bonds have become sharply overvalued.
This new trend is clearly visible in the market for long-term government securities, which represented an oasis of security for investors in the past. Today, however, we are witnessing a change in sentiment.
The yield on 30-year government bonds has jumped to above 5% (for the first time since 2007). The chart shows that it only took a couple of years for yields to get from historically record lows to multi-year highs.
Unprecedented Bear Market in Longer Maturity Bonds
There is no doubt that we are facing an extremely significant moment in the financial market, a moment that will be remembered in the annals of economic history. We are witnessing the unprecedented largest bond decline in modern history. This sharp rise in bond yields has deeply scarred the financial markets and opened a new chapter in their history.
What is particularly interesting is that this market did not just come to say 'hello’ but has been going on for 38 months.
This slump led to record losses for investors in the bond market. The current price decline of the comprehensive aggregate index of US Treasuries exceeds 15%.
However, this challenging development also presents an opportunity. History and data clearly show us that when central banks stop the cycle of interest rate increases, or even start to lower them, bonds will catch a tailwind and offer investors interesting returns not seen for more than 15 years.
Past developments and the current outlook further underscore the important role of bonds in portfolio diversification and proper risk management in the investment world. Despite the current state of the market, bonds remain an attractive option for investors.
At the same time, however, they challenge established investment theory, which also guides the legal regulation of the investment world, raising the question whether bonds can continue to be seen as a conservative instrument suitable for cautious investors who do not want to see the value of their assets fluctuate.
The following chart shows the declines in an index covering the entire US bond market, including government and corporate bonds of various maturities. Bonds are experiencing their deepest decline since at least 1976.
Domino Effect on Corporate Bonds
Changes in bond markets have clearly reflected the classic relationship between interest rates and bond prices. This effect of interest rates was not limited to government bonds, it also extended to corporate bonds.
The evolution of bond markets has not bypassed investment grade (top-rated) corporate bonds, traditionally considered a safe and secure investment. Today, these bonds offer an extremely attractive yield of 6.3% for large US corporations.
Such a yield level has not been seen since June 2009. This figure looks like a star in the financial sky and opens up new perspectives for investors.
Just imagine that if you decide to invest your capital in bonds issued by reputable corporations, you can expect a return of 6.3% on the investment. Compared to the market we saw a few years ago, this is a fundamental change that is not only attracting the attention of investors, but also changing the game for people looking for safe and stable investments.
However, the rise in corporate bond yields also brings other concerns. Higher interest rates are making it more expensive for companies to borrow and complicating the ability of companies to raise external capital.
Going forward, a wave of bankruptcies by companies with weak finances, low revenues and high debt levels cannot be ruled out when time comes to pay back obligations and refinance debt. Investors should therefore be cautious when deciding to whom to lend their savings.
An article we wrote three years ago on the risks of local non-traded corporate bonds is becoming very relevant again. All investors should follow the recommendations made therein so that they don’t end up filled with regret. The Central-European market could see our warnings coming true three years ago in the case of the Arca group's liabilities, which have not yet been resolved and investors still have not got their money back.
Cash is King Again
Remember the era when they used to say that "cash is trash"? Those words, at least temporarily, are gone. Short-term investments in cash instruments, such as US 3-month Treasury bills, now provide a return of 5.63%, the highest level in a very long time.
If you choose to invest your money in this safe and short-term investment, you can expect returns not seen since 2001. This rate of return brings a significant change in the perception of cash as an investment option.
Please note that these are U.S. dollar denominated securities, so in this case the investor must also consider currency risk, which can cut out a large portion of the return or lead to a total loss on the investment.
The returns of the euro money market on the old continent, where interest rates have also risen, are also very attractive, although not to the same extent. For example, the 3-month German treasury bill currently offers a yield of 3.7%.
Investors are now asking whether to leave money in bank or term accounts when there is such an attractive option.
The perception of cash and short-term investments is changing rapidly, opening up interesting possibilities. We at Finax feel the mood of the market too, which is why we have designed a product that reflects the current interest rates, being able to appreciate your short-term money that would otherwise yield nothing in a bank account.
We've launched a new product, Smart Deposit, which will ensure that your money generates returns at market interest rates without the requirement to fulfil special conditions or tie up your money for a specific period. Now is the time to take advantage of the change in market interest rates and make the most of them for yourself.
From Risky to Profitable – a Remarkable Turnaround in Bonds
As 2021 was drawing to a close, many experts viewed bonds with a high degree of caution. At the time, they were described as high-risk investments with limited earnings potential. In less than two years, however, things have changed dramatically. Bonds suddenly became the subject of much attention and, more importantly, a potentially lucrative investment.
Let's look at a chart that shows the changes in the returns of various asset classes in less than two years. It clearly demonstrates that all debt securities have seen significant changes in yields over the last two years. Only the dividend yield of the S&P 500 Index, which has remained almost flat, saw less growth.
In general, investors are in a much more favorable position than they were in 2021, and the bond market hasn't seen such a favorable period since 2007.
This extraordinary financial adventure of bond yields, from the record lows in 2020 when the world was gripped by pandemic chaos to today's high yields, is not only fascinating but also confirms the difficult predictability of financial markets and highlights the need to follow basic investment rules.
The opportunity that bonds now provide represents an extremely attractive option, the likes of which we have not seen in the last twenty years. It certainly deserves our attention.
The seismic shift in bond markets underlines the importance of diversifying our investments. Diversification of investments is a key strategy that helps investors reduce risk and increase potential profits.
This is important because markets are unpredictable and different asset types react to economic changes in different ways. Diversification allows us to better absorb losses in one sector while maintaining the growth potential and stability of our portfolio.
We should also not forget about an appropriate investment time horizon, which plays a key role in achieving financial success. A longer time horizon allows us to better exploit the power of compound interest and eliminates market or interest rate risks.
This means that long-term investors can achieve greater capital growth because their investments have more time to grow and recover from market fluctuations. On the other hand, short-term investors are often more exposed to market volatility and have less time to recover.
The latest market phenomenon is the return of interest in short-term investments in cash instruments.
Although we are in this volatile market environment, the rise in interest rates on term savings products continues to lag behind market rates. To encourage banks to increase interest rates on deposits, we should consider better alternatives such as short-term bonds from developed economies, ETFs linked to central bank interest rates or affordable money funds.
Don't forget our most conservative product with minimal volatility, the Smart Deposit, which allows you to take advantage of rising interest rates without restrictions and, for Slovak tax residents, without a tax on returns if the conditions are met.
It is important to remember that capital markets are constantly striving to grow and adapt, despite the challenges that arise with change and technological innovation. Crises and complicated situations, regardless of their complexity, have often acted as a stimulus for innovation and the creation of new market opportunities.
No-responsibility disclaimer: All information provided is for educational purposes only and does not constitute investment, legal or tax advice or an offer to buy or sell any security.