How Bad Can This Bond Crash Get? | Financial Advisors

Bond prices are in free fall and have been for about five months. That means that financial advisors who use bonds and bond portfolios in their practices have to do something they have likely never had to do: explain to panicked clients why the part of their portfolio designed to offset the risk of their equity investments is failing them.

Bond price declines are happening so fast and with such big downward moves, it’s fair to say that advisors and their clients have not ever had to deal with this. Now, they have no choice. Just hoping it gets better is too dangerous for those in retirement or nearing it.

The Point of ‘No Returns’

Since the start of December 2021 through market close on May 4, the total return, including income, of the iShares Core US Aggregate Bond Exchange-Traded Fund (ticker: AGG), a commonly-used benchmark for the investment-grade bond market, is down about 10%.

The iShares iBoxx $ Investment-Grade Corporate Bond ETF (LQD) is down about 15%.

Meanwhile, the iShares 20+ Year Treasury Bond ETF (TLT), which tracks 20 to 30 year Treasurys, is down more than 20%.

That’s right: Long-bond investors have seen one-fifth of their investment vanish in five months.

High-yield bonds have dropped only 5% but are just as vulnerable as other bond categories, if not more so, due to their weak credit quality and the rapidly deteriorating credit conditions for highly leveraged corporations. The Federal Reserve has come to their rescue for the past six years, but the Fed has a lot on its mind right now and seems determined to fight inflation at the cost of nearly everything else… including bond prices in your clients’ portfolios.

Here are three possible paths from here that help advisors make sense of what is possible and start down the road of calming nerves and introducing alternative solutions.

Path 1: This Is the End

In this case, this is the end of the decline.

Interest rates do look a bit stretched on the upside, which is the same thing as saying that bond prices may have experienced the majority of their declines for now. But a pause in the calamity could be the very best situation for advisors since they can take a breath, explaining to their clients what happened, why it happened and collaborate with them to determine if they are willing to ride it out. At some point, rates will peak and decline. But the longer-term chart view of interest rates and bond prices makes this more like wishful thinking than a plan on which to rest your practice’s reputation and revenue.

Buying the dip worked for a while in stocks, and it might work here and there for bonds. But until the long-term downtrend in prices, upward trend in interest rates and concerns about credit conditions and liquidity all reverse in earnest, the idea that this was all just a bad dream may be farfetched. Investors will not likely wake up to a brand-new bond bull cycle any time soon. So for advisors, this is not an issue you can ignore and hope it goes away.

Path 2: We’ve Only Just Begun

In 2020, some types of bonds crashed with equities. But those were the types that were more correlated to equities, such as preferred stocks, convertibles and high-yield bonds. On the other hand, Treasurys were solid, if not spectacular.

Back then, investors fled to the perceived safety of Treasury bonds. This time around, Treasurys are a central part of the problem as the Fed is forced to raise short-term rates, and long-term rates are being hijacked by bond market bears.

Meanwhile, recession fears have been stoked because one of the most reliable indicators of economic contraction, which is the 10-2 Treasury yield spread, created an inverted yield curve. More importantly, it soon reverted to its normal, upward-sloping shape. That is what historically starts the clock ticking on recessions.

But this recession may be different than every recession in recent memory: It is accompanied by high inflation. But that economic stagnation combined with surging inflation threatens to bring “stagflation.” That’s about the worst economic condition short of a depression.

You see, rising prices are OK if the economy is growing. When the growth is not there, you experience rising prices without a commensurate rise in employment, consumer spending and other economic boosters. Do a search for “1970s economy” for more on this. Most of today’s investors only know about it if they read it in economics class back in college.

Path 3: The Long and Winding Road

This pathway focuses on China. Given China’s latest economic stall due to tight COVID-19 lockdown policies, investors can expect further negative impacts from both limited Chinese economic output as well as its needs for some goods.

A constrained, low-growth China is one part of a long-term malaise scenario, where the pace of bond price declines slows and rates rise at a slower pace, but the trend remains stubbornly higher until inflation is crushed by the Fed and other central banks.

It is not hard to imagine why this scenario is a realistic one. Investors spent 12 years in economic conditions where, no matter how much money folks wanted to borrow, they could. Now that they need to pay it back, and rising rates combine with floating payment rates to squeeze consumers, it’s all coming together at once … in a bad way.

To make matters worse, China is one of the biggest holders of US Treasury debt. If that nation’s government decides to pursue much more nationalist policies than it already does, it’s possible they could sell a larger chunk of their Treasury holdings as part of that mission. That could be another technical factor that contributes to the long-term stress for bond investors.

Silver-Linings Playbook for Advisors

At some point, investors will look at their screens and see higher rates than they have seen in a long time. Then they will see those rates start to dip, then dip some more. That might finally be the point at which bonds can go from what they are today (a disaster area, threatening to get worse) to what they were in the 1980s (an opportunity to lock in excellent long-term, inflation-beating yields at levels that may even rival long-term stock returns).

That’s all likely in the future. But to reach that point, there will likely be one of a few paths that advisors and investors will have to endure.

That’s why this is the time for advisors to use this as a teachable moment. This bond crisis can be an impetus for advisors to change client mindsets about the tools they use to reach objectives instead of a predicament that only serves to compound their stock market woes.

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