Bond market woes create investment opportunities

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Bonds are the new sexy.

It seems counter-intuitive. Thanks to persistent inflation, higher interest rates, Russia’s invasion of Ukraine and a global economy in the grip of a pandemic, bond markets are experiencing their worst year since the First Opium War (in 1842). It is a historic crater in which investment-grade U.S. government and corporate bonds have fallen from four decades of growth to lose almost 10% so far this year.

The enticing news: Wealth advisers say investment-grade bonds have gotten so cheap they’re currently a relatively decent buy as a potential buffer for stocks – now suffering their own misery, with the S&P 500 index of major U.S.-listed companies down just over 17% so far this year. All of this makes fixed income “a very worthwhile investment today,” said Jesse Stumpf, principal and head of fixed income at Kovitz Investment Group Partners, a Chicago-based wealth management firm.

How Bonds Work
Bonds preserve capital and provide predictable income by paying investors a specified rate of interest – the “coupon– on their terms and reimbursing the holders for their initial expenses. The term, or “duration”, can be as short as a few days or as long as 30 years. The amount of profit an investor makes, or the “yield,” reflects a bond’s coupon divided by its market price.
When interest rates rise, bond prices fall, as their coupons become less profitable. Bond prices and yields also move in opposite directions, a relationship that helps keep older bonds with smaller coupons competitive against newer bonds with higher coupons.

Let’s say you buy a 10-year bond for $1,000 with a 10% coupon, in a Example of Desjardins, a Canadian financial services company. The issuer pays you $100 a year for 10 years and then pays you back $1,000. Your return is 10%.

Now suppose you wanted to sell that bond for $1,000 earlier, but its price has risen to $1,200. Your return is now 8.33% (100 divided by 1200). Next, let’s say you’re in a depressed market like now, and your original bond is down to $800. Your return goes up to 12.5% ​​(800 divided by 100).

A particularly bright moment in the current turmoil, though not certain it will last: the yield on 30-year inflation-linked savings bonds, known as I bonds, is 9.62% over six months until October. Investors can potentially find themselves even more banked, thanks to the way the Treasury Department calculates ultimate bond rates — there’s a fixed component and a variable that can recalibrate twice a year.

Here are four takes advisors can use for clients, especially older investors whose retirement portfolios already contain fixed income securities:

Kathy Jones, Managing Director and Chief Fixed Income Strategist at the Schwab Center for Financial Research:
— Bonds are a good deal because their prices have fallen significantly. “You now have fairly competitive returns, certainly relative to the money.”

— “Our view is that if you hold a bond to maturity, even if the price goes from $100 to $95, it will still earn you $100. We believe the price decline is largely behind us. This is a better time to enter the market than to exit it. »

— “We favor higher quality bonds” because of the risk of recession. “You don’t want to be in lower quality credit obligations because if there’s going to be a default, it’s going to be in these.”

— Jones noted that a leading index for investment-grade seven-year bonds is around 4.5%. Want to make a shorter-term bet? “You can get a five-year corporate bond with a yield of 3.7%,” she said. “It’s a very good opportunity.”

– “It’s a similar story with the municipal market, especially for people in the higher brackets or high-tax states.” (Municipal bonds are exempt from federal taxes.)

Mary Ellen Stanek, President of Baird Funds, Founder and Co-Chief Investment Officer of Baird Advisors and Head of the Firm’s Fixed Income Strategy, and her colleagues:
– Stanek recommended in an interview at Morningstar’s annual investing conference last week that investors invest “a few more percentage points” of a total portfolio in bonds.

— When the current state of the market hurts, think of the bugs: “It’s like a bee sting: you stop and say, I’m fine.”

– Learn from the past: “You want to recalibrate when the sun is shining, not when the storm clouds are coming.”

– Stocks have long been seen as the only viable investment – what market strategists call “TINA”, because “there is no alternative”. Jay Schwister, managing director and senior portfolio manager at Baird Funds, said in an interview that this is no longer the case. “The TINA world is over. There are viable alternatives.

— Duane McAllister, co-head of the municipal sector and senior portfolio manager at Baird Funds, looked at annuities, which are often seen as a competitor to bonds. “You can get the same income from a bond as you can from an annuity,” he said. “The difference is that an annuity takes all of your income.” McCallister compared annuities, which require heavy upfront outlays, to the song “Hotel Californiain which “you can check out whenever you want but you can never leave” without losing money.

Jesse Stumpf, Principal and Head of Fixed Income at Kovitz Investment Group Partners, a Chicago-based wealth management firm:
– Tax-exempt municipal bonds “offer a ton of value for high-income earners.”

– Right now, investment grade munis yield around 3%, like treasuries. But because the munis are not taxed, their return is more like 5%. “Mus are much more attractive than they were in 2021. We are moving a lot of our investors who were in the taxable bond market into munis.”

— Most bonds have fixed interest payments. But floating rate securities have payments that adjust to reflect changes in interest rates. As such, they “offer a downside-free return if rates continue to rise,” Stumpf said.

— Bond and stock markets generally do not move in parallel. But with the two declines this year, holding shorter-dated bonds can be a win. “The duration limit allows for rebalancing if equity markets continue to sell off,” Stumpf said.

— With the highest inflation in 40 years, “it’s pretty dangerous to stay in cash right now. The smarter approach is to get into fixed income securities with limited duration and limited interest rate sensitivity. You can earn a limited return. We don’t buy anything beyond a six-year maturity.

— “The bond market is much healthier today than it has been for the past two years. Yields have increased significantly, so it is much harder to lose money today than it was two years ago.

Jim Pratt-Heaney, founding partner of Coastal Bridge Advisors in Westport, Connecticut:
— “The supply of bonds is not keeping up with demand. As rates rise, issuers are less likely to issue new bonds.

– Many investors have bought tax-exempt bonds in recent years “in the belief that estate and tax rules were going to change for 2022”. They stayed put, so investors sold. retail investors sold their mutual funds and exchange-traded funds with munis. “These buybacks prompted portfolio managers to sell bonds in a declining market, which fueled itself as prices fell.”

— With current high-quality municipal bond yields around 4.25%, “you can buy and reinvest the cash flow at these low prices. Why sit in a low-yielding taxable money market? »

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