Market Musings 051122: Does a bombing bond market herald a bonanza in 2023?

Market Musings 051122:
Does a bombing bond market herald a bonanza in 2023?

The 2022 bond market horror show could presage a huge comeback in 2023

SUMMARY

• Fed chairman Jerome Powell signals higher US interest rates ahead
• Bond markets have so far delivered terrible performance this year
• Previous years where US bonds lost 5% or more, the next year saw bonds rebound smartly
• Today could be an excellent entry point for bond investors
• Certain segments of stock markets could also benefit from falling long-term interest rates

PODCAST

Energy Efficiency

Why talk about energy efficiency? Edmund Shing, Global Chief Investment Officer at BNP Paribas Wealth Management, discusses the importance of #energyefficiency.

He describes the events over the past year that have ushered in a new era of #energy provision and explains what nations and the #EuropeanCommission are doing to adjust to changes in supply and demand.

2022 has been a bond bloodbath

Long-term government bond indices have traditionally been a safe haven for conservative investors, on the basis that they deliver relatively consistent returns to investors in the form of fixed coupons, have a very low (even negligible) risk of default (i.e. of investors not receiving their full principal amount invested back when the bond matures), and are typically not volatile at all, usually going up when stock indices decline.

2022 has been a huge outlier for bond investors: long-term US, UK and Eurozone government bonds have all lost between 31% and 39% so far this year in their respective currencies, underperforming their local stock markets in each case.

2022 has been a horror show for long-term bond investors

Source: Bloomberg

For the period 2012 to April 2020, US and UK government bonds were showing very healthy long-term returns (capital gain + coupons received) of 6.6% per year (CAGR: compound annual growth rate) for US long-term Treasury bonds and 8.5% CAGR for UK long-term gilts.

However, following this year’s bond bear market, these 10-year returns have been reduced to almost zero…

The 2022 bond bear market has wiped out US, UK bond returns since 2012

Source: Bloomberg

The 2022 bond bear market is unprecedented…

To shed some historical light on the scale of this shock to bond markets, just look at annual returns from US Treasury bonds since 1928. There is no other year that comes even close to the damage done this year. Over 2022 to date, US 10-year Treasury bonds have returned -19.2%. The next worst year over the last 95 years for bonds was 2009, when US 10-year Treasuries returned -11.1%. On average, over these 95 years US 10-Year Treasury bonds have delivered an annual 5.1% average return.

No other year from 1928 comes even close to this year’s carnage in bonds

Source: BNP Paribas

Note that even during the inflationary 1970s decade, US bond returns were relatively healthy. Note too from this chart that it is very unusual to have two negative years of bond returns in a row - this was last seen in the 1950s, but even then, the bond returns were only modestly negative each time. Nothing like the scale of the losses experienced today.

The silver lining for bond investors, from here

There is a silver lining for shell-shocked bond investors, from this point on.

I would suggest that inflation rates have, or are about to, peak and then start to decline. Economic demand is slowing quickly on the back of the combined pressure from higher prices and from higher financing costs. Supply chain issues are easing after COVID-related disruptions last year which should help to stabilise goods prices, and even energy prices are on their way lower.

I believe that inflation rates will start to fall soon in Europe, and are already falling in the US. I further believe that this fall in inflation will accelerate over the coming months, and could even surprise economic observers and investors alike.

With central banks such as the US Federal Reserve and the Bank of England potentially signalling a slowing of the pace of future rate hikes over the next few months, we can see bond yields are starting to anticipate this change in tone from central bank governors. Typically, bond yields peak about 1-2 months before a peak in central bank base rates - so if you expect central banks to stop raising their reference interest rates (such as the Bank of England base rate) early next year, we should expect bond yields to peak very soon if not now.

Indeed, 10-year bond yields look to be peaking today, and may soon start to fall back after what has been a very sharp rise so far this year.

Remember that at the beginning of 2022, the UK government was able to borrow money for 10 years at a rate of just 1%, but now has to pay 3.5% for the same privilege today.

10-year US, UK and Euro government bond yields could be peaking now

Source: Bloomberg

Looking back once again at history, note that on each occasion that US 10-year Treasury bonds suffered an annual loss of 5% or more, the following year saw a sharp rebound in bond market performance of 14% on average.

Following a poor year for US bonds, the next year saw positive bond returns

Source: BNP Paribas

While 2022 has been an annus horribilis for bond markets worldwide, 2023 could see a big rebound in bond market performance given historical precedents and the expectation for a substantial fall in inflation rates.

Conclusion

Conservative bond investors could be forgiven for wanting to sell their bond exposure after a historically awful year from what are supposed to be low-volatility, boring investments.

But history suggests that investors should do the opposite, and actually increase exposure to bonds at this point given that bond yields on offer today are the highest since 2008 in the case of US Treasuries, and since 2011 for UK gilts.

There are a number of easy ways to invest in long-term bonds today via ETFs:

• For UK government bonds (gilts), there is the VGOV Vanguard UK Gilt UCITS ETF. For investors who specifically want exposure to long-term gilts, there is the GLTL SPDR Bloomberg 15+ year Gilt UCITS ETF.This latter ETF yields around 3.3% at present.
• For US Treasury bond exposure, you can look at the IBTL iShares $ Treasury Bond 20+yr UCITS ETF, which offers a 2.9% yield.

For investors prepared to look at single issuer bonds and preferred shares, there is a wide selection of long-term UK corporate bonds (often perpetual, i.e. with no set maturity) which can offer high yields at present, from issuers such as building societies and insurance companies.

For more information on this sector, I would refer you to Paul Scott’s recent interview with Paul Hawkins, a corporate bond specialist.

For stock market investors, there are several ways to benefit from slowing inflation rates and potentially lower bond yields.

• US Real Estate Investment Trusts should benefit from lower long-term US bond yields. In 2010, as US 10-year bond yields declined sharply, REITs returned 28% over the year (versus 15% for the US S&P 500 index); look at the IUSP iShares US Property Yield UCITS ETF.

• US high dividend stocks performed strongly as bond yields declined in 2010, gaining 21% versus the S&P 500’s 15%.There is the UDVD SPDR S&P US Dividend Aristocrats UCITS ETF
  
• European mining stocks rebounded very strongly (+29%) over 2010, outstripping the STOXX Europe index (+12%) as investors looked through recession to the economic recovery beyond. Today, any change in China’s zero COVID policy to gradually reopen their economy and help domestic demand could also boost commodity demand, which in turn could help global mining companies. One could consider the GIGB VanEck Vectors Global Mining UCITS ETF for exposure to this sector.

Have a great week,

Edmund