Welcome to the Three Edge Week in Review, where we discuss important topics related to investment strategies. In this article, we explore the reasons why U.S. treasuries, typically considered risk-free investments, may not always be as safe as they seem.
We will delve into the factors that can lead to potential losses in bonds and how investors should approach portfolio positioning in light of these risks.
I. Review of the Global Capital Markets
- Positive returns in U.S. equities and technology stocks rebound: In the first quarter of 2023, U.S. equities recorded their second consecutive quarter of positive returns, driven by a strong rebound in technology stocks, marking their best quarter since mid-2020.
- European equities and gold outperform the S&P 500 Index: Both European equities and gold outperformed the S&P 500 Index during the first quarter of the year.
- The inverted yield curve and recession concerns: The yield curve remains inverted, indicating that short-term yields are higher than long-term yields. This inversion suggests investor concerns about the economy’s strength and the possibility of a looming recession, which could prompt the Federal Reserve to cut interest rates.
- Cash flow into money market mutual funds: Money market mutual funds are attracting significant cash inflows as individuals withdraw funds from bank deposit accounts in search of higher yields. Approximately five trillion dollars worth of bank deposits has been redirected to money market mutual funds, potentially posing risks for both banks and the economy.
- Core PCE inflation index remains elevated: The core personal consumption expenditures (PCE) price index, which is the Federal Reserve’s preferred measure of inflation, showed a slight decline in inflation from the previous month. However, inflation remains stubbornly above the Fed’s target of two per cent.
II. Understanding the Risks in Bonds
- Default risk: Bonds carry the risk of loss if the issuer, such as a company or organization, goes bankrupt or faces financial difficulties that prevent them from repaying the bondholders. This risk was evident during the 2008 financial crisis when many low-quality bonds defaulted, leading to significant problems in the bond market.
- Interest rate risk: Buying long-term bonds exposes investors to the risk of declining bond prices when interest rates rise. As interest rates increase, the market value of existing bonds with fixed interest payments decreases. This situation occurred more recently when banks and institutions, like Silicon Valley Bank, bought long-term bonds at historically low-interest rates. When interest rates rose sharply, these investments incurred substantial paper losses, highlighting the inverse relationship between bond prices and interest rates.
III. Historical Perspectives on Portfolio Strategies
- The success of the 60/40 portfolio: Over the last four decades until 2020, the 60/40 portfolio allocation (60% equities and 40% bonds) proved effective as bonds acted as a hedge for equities. When equities performed well, investors profited from their equity allocation, while bonds provided returns during equity market downturns.
- Bond market cycles: Bonds experienced a remarkable bull market from 1980 to 2020, resulting in substantial returns above inflation. This extended period of declining interest rates and inflation significantly benefited bond investors. However, the current regime suggests a potential shift as interest rates hit historic lows in 2020, signalling a different market environment.
- Challenging periods for long-term bond investors: Examining the period from 1940 to 1980, we observe a 40-year bear market in bonds, characterized by rising interest rates and inflation. Bond investors during this time experienced losses relative to inflation, highlighting the risks of long-term bonds. Comparing this period to the previous four decades, it becomes clear that bonds are not immune to significant risks and losses.
IV. Navigating the Risks: Adjusting Portfolio Strategies
- Diversification beyond U.S. treasuries: While U.S. treasuries are often considered safe havens, diversifying beyond them can help mitigate risks. Investing in a mix of different types of bonds, such as corporate bonds, municipal bonds, or international bonds, can provide a more balanced portfolio and reduce exposure to specific risks associated with U.S. treasuries.
- Shorter duration bonds: As interest rate risk poses a significant threat to bond investments, investors may consider allocating a portion of their bond portfolio to shorter-duration bonds. Shorter-term bonds are generally less sensitive to interest rate fluctuations and can provide more stability in a rising interest rate environment.
- Active management and bond selection: During periods of changing market conditions, active management of bond investments becomes crucial. Skilled bond managers can navigate the risks and opportunities in the market by selecting bonds with strong credit ratings and monitoring potential default risks.
- Dynamic asset allocation: Instead of adhering to a static asset allocation strategy, investors should consider implementing a dynamic asset allocation approach. This strategy involves adjusting the allocation to different asset classes based on prevailing market conditions and economic indicators. By actively managing the portfolio allocation, investors can better position themselves to capture opportunities and mitigate risks in the bond market.
While U.S. treasuries have long been regarded as safe investments, it is essential for investors to recognize that they are not without risks. Factors such as default risk and interest rate risk can lead to potential losses in bond investments.
By diversifying beyond U.S. treasuries, incorporating shorter-duration bonds, actively managing bond selections, and employing dynamic asset allocation strategies, investors can better navigate the risks associated with bond investments. In today’s ever-changing market environment, understanding the risks and adopting proactive strategies is crucial for investors seeking to achieve their financial goals.
By staying informed and adapting to market conditions, investors can position themselves for long-term success while effectively managing the risks inherent in bond investments.