Bond market ‘bloodbath’ opens a door for income investors

As fixed income suffers the brunt of the Fed's efforts to catch up on inflation, financial advisers suddenly have an alternative for short-term cash allocations.

With the overall bond market rolling into 2022 with its worst total return performance in 40 years, financial advisers face new challenges and opportunities when it comes to the fixed-income side of client portfolios.

On the one hand, bond yields have been climbing so rapidly in response to the Federal Reserve’s efforts to tamp down the rate of inflation that income investors suddenly have a less risky alternative to any income they can get in the equity markets.

Three-year Treasury notes, for example, are now yielding around 2.77%, which compares to just 0.33% a year ago. While that’s still well below the inflation rate of around 7%, it is a vast improvement in a short period of time for investors who might appreciate the opportunity to move away from the relative risk of stocks compared to bonds.

“If you’re looking at yields around 3% and compare that to the equity risk premium, there’s an argument to be made that you can lock in some gains,” said Ella Hoxha, senior investment manager at Pictet Asset Management.

“We would say some value is emerging in the front end of Treasury market if you just sit on them,” Hoxha added.

The yield curve has gotten so flat that there’s almost no reason to move out beyond a few years for investors who can hold the bonds to maturity, said Max Wasserman, founder and senior portfolio manager at Miramar Capital

“With the five-year Treasury yielding 2.91% and the 30-year yielding 3.12%, you’re getting 93% of the return of the 30-year while taking a lot less maturity risk,” Wasserman said. “For an individual investor, there’s no reason to go out beyond five years.”

Paul Schatz, president of Heritage Capital, is making the most of what the market is offering in this unique period of rising rates, spiking inflation and negative economic growth in the first quarter.

“I think bonds offer better risk-reward than stocks for the rest of 2022, although I don’t think yields have peaked just yet,” he said. “Yields look to be in the process of peaking, and that high should be in place this quarter.”

With the Fed expected to hike interest rates by another 75 basis points in June, the bond market may still be a long way from stability, which is where the challenges come in.

“People thought January and February were tough months for bonds, but April has proven to be a very tough month,” said David Sherman, founder and portfolio manager at CrossingBridge Advisors.

“The Fed has messaged very successfully that they were going to raise rates and that they are committed to fighting inflation,” he added. “The fact that the market has reacted and people seem dumbfounded by this reminds us of the old saying that you don’t fight the Fed.”

Even for those paying the closest attention, the abrupt pullback in bond prices, which move inversely to bond yields, has been jarring.

The yield on the 10-year Treasury, for example, is currently hovering around 2.89%, which is up from 2.33% a month ago, and up from 1.51% on Jan. 1.

While some individual investors can find temporary comfort in shorter-term bonds if they hold them to maturity, the larger portfolio managers and pension funds have no such luxury because they live in a world of total returns, which are dropping as interest rates climb.

“There are very few spots to hide,” said Hoxha of Pictet Asset Management. “You would characterize this as a bloodbath, with a bad quarter followed by a bad month.”

While total return drawdowns across the fixed-income space of between 5% and 10% this year might not seem so bad compared to a nearly 12% drop by the S&P 500 and a 20% drop by the Nasdaq, Hoxha said the bond market is “your coupon-clipping asset class.”

“Safe doesn’t mean you never lose money, it means you lose less,” she added.

If there is a silver lining for bond fund managers and the people who invest in them, it’s that this is an ideal environment for active management.

Sherman of CrossingBridge said the dynamics at play in the bond market are creating mispricings that can’t be captured by indexed strategies.

“I think you need an active management because credit quality is going to be more uncertain, and you’re looking for people who are trying to avoid negative beta,” he said. “I think there’s plenty of very interesting opportunities.”