The Bond Market Crisis of 2022: Lessons Learned
2022 marked the worst year in bond market history. The Total Bond Index, which tracks U.S. investment-grade bonds, saw prices plummet more than 13%. Prior to 2022, the index had suffered its worst 12-month return in March 1980, when it lost 9.2%. Inflation has unleashed a staggering amount of damage to fixed income markets, made worse by massive amounts of government spending and misguided Federal Reserve policy. The Fed held interest rates at historically low levels under the false assumption that inflation would be “transitory”. Pumping an enormous amount of money into the economy inflated everything—stocks, bonds, real estate, commodities, and wages. As a result, our debt level in relation to GDP (Gross Domestic Product) has reached a dangerously high record level.
For many years, we have been warning clients and the public that ultra-low interest rates were dangerous to long-term bonds and mortgage investments. When over 25% of the world’s government bonds had negative yields, something is amiss! To mitigate the risk in a rising rate environment, we favored short-term bond maturities, low duration, and focused on the highest quality bonds, constantly reminding investors what would happen when interest rates rose. We just didn’t expect that professional investors would fail to understand the risks and we view the latest banking crisis as a failure in bank management and regulatory oversight.
The Fed’s Response to Inflation and Its Impact on Markets
Last year, the Federal Reserve was compelled to raise interest rates quickly in an effort to rein in rampant inflation, which was fueled by restrictive energy policies and large amounts of government spending.
This rapid increase to the federal funds rate quickly added to the costs of everything, while increased inflation and interest rates led to selloffs in bonds and equities, resulting in lower asset values. This created serious problems for asset holders of stocks, bonds, and commercial real estate, many of whom had pledged these assets as collateral for loans. These loans are now underwater.
Since the leveraged real estate cycle of 2008, which toppled the banking and insurance industry, interest rates had remained low—so low that over 25% of bonds around the world experienced negative yields, as we previously noted. Central banks worldwide flooded markets with liquidity through Quantitative Easing (QE), with the Federal Reserve buying junk bonds from banks and dealers to prevent a collapse. This massive liquidity injection pushed interest rates to record lows, with savers and taxpayers bearing the brunt of government and Federal Reserve policies.
Low interest rates allowed businesses and consumers to refinance their debts at lower rates. However, when interest rates rise, asset values fall, hurting all parties involved—lenders, borrowers, and asset holders. Banks, in particular, suffer because they operate with very little equity, usually between 5% and 10%. When loan or bond values decline more than their equity, banks and borrowers face negative net worth, which is precisely what happened with Silicon Valley Bank (SVB).
As we discussed last month, in order to restore confidence in the banking system and mitigate the risks of further contagion spreading to other regional banks, the Fed intervened, saving bank depositors, even those exceeding the $250,000 FDIC insurance limit. As a result, the bond market has experienced a significant rally, with bond prices increasing and interest rates decreasing, mitigating bond losses (see chart right). There is renewed hope in the markets that the Fed may have reached the end of its tightening cycle and could cut interest rates, potentially even this year.
Volatility is likely to persist as markets navigate the most recent banking crisis and the subsequent response by the Federal Reserve and the Treasury. Inflation data and economic conditions will ultimately drive Fed policy, but a pause to its current rate hiking cycle in the wake of the March banking crisis is certainly a possibility. Businesses have experienced a rapid increase in borrowing costs, as the Fed has taken the federal funds rate from 0.25% to 4.25% in a short period of time, this is just now beginning to be reflected on profit and loss statements and marginal and highly leveraged borrowers will face dramatic changes this year. A mild recession may be on the horizon.
Inflation is always and everywhere a government issue.”
– Milton Friedman
The global economy, including China and Europe, continues to grow, supporting the U.S. economy and maintaining pressure on higher inflation. Lower rates in the U.S. will preserve growth but also contribute to inflation, putting pressure on the Fed to continue raising interest rates. The saying goes, “the Fed raises rates until something breaks.” The banks’ recent actions have signaled to the Fed that they are becoming a problem.
Managing Risk in Bonds
To mitigate the negative effects of rising interest rates, we have focused on short-term, low-duration, and high-quality bonds. These investments may generate lower income in the short term, but they offer greater safety and help preserve principal during volatile market conditions.We have consistently warned against investing in long-term bonds, and our clients’ short-term bond investments have kept them relatively unscathed during the worst bond sell-off in U.S. history.
We have also cautioned against high yield or junk bonds, as they are likely to be the next casualty of rising rates. Credit spreads widened during the recent banking crisis but are still calm by historical standards. This bears monitoring if business conditions weaken.
Many investors have been sold high yield junk bonds by brokerages and salesmen in search of higher income due to low returns on high-quality bonds. We have encouraged clients to review their 401(k)s, annuities, and other accounts for high yield bonds, and suggested they advise their friends, coworkers, and family members to do the same.
Looking Ahead – Emerging Investment Opportunities and Disruptive Technologies
Looking past the bond market and the current macro economic backdrop for a moment, there are a number have exciting industries and technologies that are rapidly being developed. With new innovation comes potential risks and rewards but it’s exciting to review both the complexities and dynamics of these developing industries.
The biotechnology and genetic engineering industries are making significant strides in developing new treatments and therapies for various diseases. Advances in gene editing technologies like CRISPR-Cas9 have opened up new possibilities for personalized medicine and improved healthcare outcomes. We constantly monitor companies involved in the research and development of novel therapies, as these innovations have the potential to revolutionize healthcare and create exciting investment opportunities.
Artificial Intelligence (AI) and machine learning are transforming industries by automating tasks, improving efficiency, and providing insights through data analysis. Companies that harness the power of AI to optimize their operations, develop new products, and enhance customer experiences are likely to outperform their competitors. Companies that are leveraging AI technologies to maintain a competitive edge in their respective industries also have the opportunity to increase their long-term growth prospects.
Significant investments have been made in renewable energy and electric vehicle industries and wind, solar, and hydrogen power technologies continue to gain traction. The EV market is experiencing rapid expansion, driven by advances in battery technology and supportive government policies. Blockchain technology and development of decentralized finance (DeFi) platforms has the potential to disrupt traditional financial systems and revolutionize the way we conduct transactions.
With any new industry or innovative technology, the regulatory landscape remains highly uncertain, and investors should carefully consider the risks associated prior to making any investment. However, exploring and learning about new opportunities is one of the most exciting elements of being an investor!
GICS Sector Updates: Key Changes and Impact on the S&P 500
At the close of trading on March 17th, 2023, the Global Industry Classification Standards (GICS) went through a reclassification impacting the composition of five S&P 500 GICS sectors and 14 individual companies.
The Information Technology sector will experience the largest market capitalization reduction as “Data Processing & Outsourced Services” stocks, a sub-industry classification, have been removed. Some of these companies, such as Visa and Mastercard, will be reclassified into a new “Transaction and Payment Processing Services” sub-industry within Financials. Other companies, like Paychex and Broadridge Financial Solutions, will move to the Industrials sector.
Other notable changes are retailers such as Target and Dollar Tree, formally Consumer Discretionary stocks, will now be grouped with Walmart and Costco into a new “Consumable Merchandise Retail” sub-industry under Consumer Staples.
Most sectors’ valuations, growth and quality characteristics, will see minimal changes due to these updates. However, there are some notable shifts: The Tech sector will continue to be dominated by growth stocks, despite losing 12% of its market cap. The Financials sector will see a greater allocation to growth stocks, resulting in slightly higher historical revenue growth and estimated 3-5-year EPS growth but lower historical EPS growth.
The latest GICS changes are less dramatic than those in 2018 but are still essential to understand for investors with exposure to the S&P 500. Keeping track of these updates helps inform future investment decisions and portfolio construction.
Chart of the Month – GICS Changes
