The betrayal of bonds

For the last several decades, investors have enjoyed a benevolent and generous bond market, giving us reason to trust in this sector's "safe haven" reputation. 

But now, we've been betrayed. Rising rates meant to cool inflation could lead to a long period of negative real returns in the bond market. Unlike stocks, the corporate bond market will not likely bounce back after rates stabilize. Best case scenario, bonds will just go back to being, well, boring. 

We all crave the safety, consistency and predictability that we've associated with bonds, the designated driver to our tipsy friend, equities. Now that this asset is proving underwhelming, advisors and their clients need to recalibrate expectations and reposition portfolios for today's market environment.

Ask the question "What are investors seeking in fixed income?" and the answer will usually involve a few mundane points about stability, yield, risk management and limited growth. Snooze. However, bonds are supposed to be boring and safe. That's what we're used to, and that's the way we like it. In late July, aggregate bonds were down about 10% year over year and 9% year to date. This is not the way we like it. 

Investors are left questioning where the consistent part of their portfolio went, or doubting the familiar inverse correlation to equities. For years, they have chosen low fees above other risk factors yield or potential growth. Now, investors are reevaluating their priorities as price matters more in the absence of value.

When we look to the past, we see another generational bias toward bonds. During the Great Depression, Americans were understandably terrified of the catastrophic gyrations of the stock market and found comfort as bond yields decreased through the 1930s, producing a return of 6% while the Dow Jones was down around 40% during that decade. This bias lingered through the following bull market in stocks that lasted from 1942 until 1969. In the early 1940s, the 10-year Treasury dragged along the bottom between 2% and 3% (sound familiar?) before we entered a fixed-income bear market from the mid-1940s that lasted until the early 1980s. 

To be sure, I'm not making any predictions about a massive bull market in stocks coming our way. Quite the contrary. We had a GDP of 9% in the 1940s and were rebuilding the world after World War II. Nor can we predict the depth or duration of the rout we're now experiencing in bonds, but it's clear to me that the time for cheap exposure to bond funds is done for the foreseeable future. 

Active rising
For a while after the 2008-09 financial crisis, passive investing reigned. Now, not so much. Inexpensive exposure to passive fixed-income funds is no longer our friend. There will always be a place for cheap passive investing in equities, as investors can comfortably anticipate a bounce-back after a decline; corporate bonds don't share that luxury, which is driving up demand for an active approach to circumvent a depreciating market. 

Active investing offers more agility, adaptability and potentially higher returns in the face of uncertainty. With inflation on offense, investors have their guards up. Though it's difficult to forecast what's next, looking at the historical trends can offer guidance for active strategies. It is time to look for nimble fixed income that can adjust to historical patterns from past periods of inflation and war, and temper that with a dash of good old unpredictability. 

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During the last financial crisis, stocks dropped 55% but aggregate bonds increased 7%, causing a balanced portfolio to be down about 30%. If stocks repeat that performance this time, but bonds fall by 20%, a balanced portfolio would be down 41% compared to 2008-09. And that's before inflation. If you peg current inflation at around 9%, then the real losses of a balanced portfolio could be about 50%. Bond losses and inflation could significantly worsen the impact on our clients.

The emotional toll of bonds' betrayal will weigh heavily on investors in the months to come, but well-equipped advisors can help their clients weather this storm. Moving forward, advisors will need to prepare their clients for a new reality of portfolio allocation. How? By setting realistic expectations for fixed income. 

Investors will likely need to shift away from the cheapest-is-best mentality, with the tradeoff being potentially increased value. All today's bond managers need to answer one question: How will you accommodate rising interest rates and inflation? If their answer is anything other than, "Bonds were designed for this kind of market," it might be time to broaden the search.