Transcript:
For the past decade, bonds have been boring. But in this video, I'll discuss the bond market and why bonds are no longer boring. In fact, bonds are attractive these days. Fixed income is still an important component of any diversified portfolio.
Bonds don't get much of the spotlight in the wider financial media. But, they can play an important role in investors' portfolios. So, lets refresh on what a bond is.
A Bond is an IOU issued by a company, municipality, or government. The issuer then pays interest and eventually the loan's principal (or IOU) over a specified time frame. What is the issuer's liability, is the creditor's asset. When an investor buys bonds in their portfolio, they become a creditor to those issuers. The investor collects the interest and principal from the bonds. Because bonds are basically loans, they tend to be less risky than stocks. The different risk characteristics of bonds can help diversify the risks of stocks in an investor's portfolio.
The bond market had a much better year in 2023 after falling into a bear market last year. The U.S. Aggregate bond index has gained 2.7% this year. While this isn't a spectacular return, it is a positive rebound from last year due to more stable interest rates, improving inflation, and the possibility that the Fed may be done with its rate hike cycle.
In fact, market-based measures suggest that the Fed could begin to cut rates next year. If this were to occur, and this is a big if, more stable and even falling rates could help to support bond prices further.
Over the next few minutes, I'll explore three key insights into the bond market that will likely be important in the year ahead.
First, this chart shows a very important bond investing concept known as duration. Specifically, we're looking at a version known as "modified duration," which tells us how sensitive bond prices are to interest rate moves.
For example, using the U.S. Treasury Index illustrated in this chart, this index has a duration of around 6.1. This means that a one percentage point rise in interest rates would lead to a 6.1% decline in the Treasury index, and vice versa.
Based on this, it's not hard to see why bonds have struggled over the past two years as interest rates have risen. Different bond market sectors have different duration estimates based on their unique characteristics. High yield, for instance, has a lower duration risk because it tends to have shorter maturities and is more correlated with the stock market, thus making it less sensitive to interest rates than other parts of the bond market. However, high yield carries additional risks not illustrated here.
Second, this chart shows how different fixed-income sectors have performed each year. We can see that many parts of the bond market have actually done well this year as the economy has grown steadily, risky assets have surged, and interest rates have stabilized.
Thus, it's not hard to see why the bond environment could improve if interest rates do stabilize and the Fed does begin cutting rates. The duration calculations we saw on the previous chart go in both directions. This means that falling rates across the yield curve could actually help to support bond prices.
But, as always, there are risks in the bond market. It's easy to see on this chart that bond market volatility has been elevated all year. The banking crisis at the start of the year and other factors have made this a challenging environment.
If interest rates do turn around, however, this could help to support bonds in diversified portfolios. This would help to reestablish the decades-old pattern of stocks and bonds balancing one another, especially over the long run.
While none of this is certain, these are all reasons for investors to take a long-term perspective and not just react to what's happened over the last couple of years.
I hope you found these insights helpful. As always, please feel free to reach out if you would like to discuss these topics and your situation further. I look forward to speaking with you soon.
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