By Finn Anderson
The bond market has emerged from a sustained period of dormancy in 2022. Fixed income (the bond market) had reached its nadir of sufferings during the global financial crisis of 2007-08, and the ensuing decade reported record low interest rates and lackluster allure in anything but equities and crypto. A bond is a debt instrument that signifies a loan made from an investor to a borrower in need of an immediate cash injection (a government, corporation, or individual). Depending on the type of bond, this loan can be paid off in regular installments of coupon (interest) and principal payments. Current market volatility has caused the prices of bonds to depreciate, but new bond yields (interest) to be higher (negative correlation to prices) and more appealing to investors. In contemporary markets, bond prices are on record to deliver their worst year since 1788; Bloomberg’s US Aggregate Bond Index, which tracks the investment grade bond market and is a popularized index for bond funds, is down 15.49% Year-To-Date (YTD), Vanguard’s Intermediate-term investment-grade Fund (VFICX), which provides exposure to medium- and high-quality investment-grade bonds, is down 17.48% YTD, and the S&P 500 Investment grade Corporate Bond Index is down a further 18.60% YTD- then why the impetus for intrigue in fixed income? The exciting price-swing nature of equities and crypto has been lacking in bond markets, but with runaway inflation being combatted by central banks, in a myriad of ways, fixed income is once-again mirroring the stimulating nature of other markets. Bonds are considered a defensive asset class, calling a boring stagnant market to mind, but current macroeconomic events have caused high yields and bond derivatives to tantalize investors.
In accordance with the second consecutive quarter of negative GDP growth reported in the summer, the U.S. may have already entered a recession. Investors have a proclivity to turn to bonds when recessions loom, as they offer more steady streams of income. Central banks, however, traditionally ease monetary policies when the economy shows signs of contraction, but central banks are instead set to induce a recession by over-tightening policies (raising interest rates) as inflation continues to rise. This suggests bonds are unlikely to protect investors from falls in stocks (because the possibility of default will be higher given increased coupon payments), as indicated by the inversion of the 2-year and 10-year US Treasury yield curve on Mar 31, 2022. The inversion of this yield curve portends a recession, as this section is typically given the most credence by investors. A yield curve plots yields (Annual Percentage Returns/ interest rates) of bonds of the same credit quality (AAA/AA/A…) but with differing maturities (1 Year/10 Year/30 Year). The inversion of a yield curve is caused by investors moving from short-term to long-term bonds (short-term rates rise above long-term rates), indicating that the market is becoming pessimistic for the immediate future, heralding a recession. Fears of a recession generally turn investors away from comparatively risky assets, like stocks and crypto, and into government bonds. However, the inversion of this yield curve coupled with continuing positive Consumer Price Index (CPI) reports (CPI is an inflation measure that rose a further 0.4% in September) connotes the continuation of bond price volatility and rising bond yields, as the central bank pushes the economy further into a recession while trying to beat inflation.
The cause of this volatility stems from the Fed’s potential two-pronged approach to controlling inflation: raising interest rates and unwinding the quantitative easing enacted following the financial crisis. By raising interest rates, the Fed hopes to raise the cost of borrowing, inciting a slow-down in economic growth. The speed of recent interest rate hikes, however, has left many susceptible to debt concerns, even innocuous pension funds. Many UK pension funds use borrowed money in the form of liability-driven investment strategies (LDI) to invest in gilts (UK Sovereign Bonds), which, during the past era of incredibly low-interest rates, was intended to function smoothly. That said, the speed of recent interest rate hikes has left pension funds incessant on raising money to cover their borrowings, causing more selling pressure on gilts, and forcing the Bank of England to intervene and stabilize the market. Following this, the Bank of England confirmed the end of its bond buying program on 14/10/22, meaning yields have continued to rise as prices fall.
Secondly, there are qualms surrounding the potential sell-off of Federal Reserve Mortgage-Backed Securities (MBSs). Following the 07’-08’ financial crisis the Fed enacted an unconventional form of monetary policy known as quantitative easing, whereby government and mortgage-backed bonds were purchased to relieve financial institutions of their illiquid debt. The unravelling of this program (decreasing the money supply in circulation, further increasing interest rates), which seems plausible given inflations unending rise, would reduce the amount held by central banks and, combined with fervent interest rate hikes, would likely push yields higher than they’ve been for some time. Therefore, there is an eagerness to predict when the potential sell-off of remaining Fed assets will occur; however, Fed Chairman Jerome Powell has allayed investors’ immediate worries as he announced that “it’s something [he] think’s [they’ll] turn to, but that time- the time for turning to it has not come,” as of September 21st, 2022. Speculative investors can utilize this looming sell-off to predict when bond prices will once-again sway dramatically.
Nevertheless, the rapid change of current interest rates prompts excitement. Fixed income has maintained a narrative of a tacitly inert market over the past decade, but with interest rates having to grow excessively to deal with inflation, bond yields have increased to pre-global-financial-crisis levels. Even with bond prices falling heavily, rising bond yields bring attention to derivatives, many surrounding Mortgage-Backed Securities (MBS). MBSs are constructed by investment banks that amalgamate mortgages of varying quality and purchase them through a special purpose vehicle (SPV), which is a subsidiary of the company. Then investors are able to purchase shares in that SPV, creating an MBS. From this, a variety of derivatives have been created including Credit Default Swaps (CDSs), interest-only and principal-only strips (IOs & POs), and Contract For Differences (CFDs), amongst others. Bond derivatives are being given proper attention because of the implications of hawkish monetary policy decisions.
Given the Fed’s perpetual intent to dampen inflation, be it through rising interest rates or the sell-off of MBSs, coupon rates have been accretive. With increasing interest rates, the intrigue of derivatives that bet against the price of bonds has risen, like IO’s, CDSs, CFDs, and inverse ETF’s. Alternatively, investors riveted by higher yields can turn to investment grade (Rated BBB<) rated bonds or even newly issued junk (high yield, BBB>) bonds, despite the higher risk of default. Although fixed-income is on track for the worst annual price performance in over two centuries, the rapid movement of interest rates (yields) arouses excitement for bonds and catapults “one of the most boring” markets in the world into the headlines. With inflation growth reluctant to cease, investors can turn to bonds for exciting alternatives to their portfolio.
The views expressed in this article are the author’s own, and may not reflect the opinions of The St Andrews Economist.