Bond Market Turmoil & Opportunity
It has been a wild 12 months for fixed-income investors. With the 10-year U.S. Treasury Yield peaking at 4.34% in October of last year, bond prices have moved sharply lower. The Bloomberg U.S. Aggregate Bond Index (the benchmark of the bond market) lost 13% in 2022, making it the worst year for the bond market in the index's history (the index was established in 1976).
The losses in fixed income have weighed on portfolios. Higher interest rates mean new bonds are being issued with higher coupons, while older existing bonds are worth less. It is the same phenomenon that has hurt bond prices during other periods of rising interest rates.
Many clients have asked us whether we should sell bonds now & move back into the bond market when rates settle. We do not believe that is a productive approach for a couple of reasons. First, the bond market is one of the most efficient markets in the world and predicting the path of interest rates is notoriously difficult. Second, when we sell bonds, we typically sell them at a loss now and reinvest in similarly priced bonds when rates settle. Third, the cash inflows from existing bonds mature at higher par values and are routinely being reinvested at today's higher rates. While it is uncomfortable to see negative returns in your "safe" portion of the portfolio, the negative returns are book losses, and your bonds are still safe. With the help of our fixed income team at Sage Capital, we have positioned client portfolios with intermediate bond ladder strategies that will mature at par & reinvest at higher rates, as the environment continues to normalize.
In summary, while the bond market has been painful, we are very excited about the opportunity set. Money market funds and short-term bonds are yielding 4.5% – 5.0%, while intermediate bonds are yielding 5.0% – 5.5%. For investors who can stomach intermediate bonds, this is a great entry point & locking in 5%+ yields on fixed income should provide strong returns for years to come.
The Banking Crisis: Lessons from SVB
The banking crisis that started in March of 2023 was the second largest bank failure in U.S. history. Silicon Valley Bank (SVB) had over $200 billion in assets & was considered to be a relatively stable bank leading up to its collapse. In hindsight, the failure had as much to do with bond market dynamics as it did with the bank's exposure to a specific sector of the economy.
When the bond market crashed in 2022, SVB's bond portfolio — like those held by most major banks — lost significant value. With these losses, the bank became increasingly dependent on its deposits to fund its lending business. Because most of SVB's clients were in the venture capital & startup space, those clients experienced significant strain on their own businesses, and they began pulling cash out of SVB at an accelerated pace. Once the bank's clients started pulling money in unison, the bank was forced to sell their bond holdings at depressed prices to meet withdrawal demands. The bank failed spectacularly within 48 hours. This story was repeated to a lesser degree at Signature Bank & First Republic.
This is a story that is well-known to our readers. In short, the lesson is that no institution is "too big to fail". Most banks had been warning for some time that they were "safer than ever" with the most stringent capital reserves & regulatory requirements in modern history. We will not pretend to think that there is anything "safer than ever" about the current banking system. Even the safest institutions are taking on more risk than many realize. As always, we believe in the importance of diversification, and FDIC insurance limits to make sure your cash is insured at the maximum level.
Cash equivalents, money market funds, and Treasury Bills at your custodian (e.g. Schwab, Fidelity) are typically insured up to $250,000 per depositor, per bank. If you have cash balances exceeding this amount, we would love to help you assess strategies to keep your cash at the safest possible levels. Some strategies include:
- Spreading cash across multiple banks (each insured up to $250k).
- Using Treasuries, money market funds, or short-term CDs that are not subject to bank credit risk.
Even if you do not have excess cash balances, the lessons from this episode are valuable. Just because something seems safe, does not mean that it is safe.
Recession on the Horizon?
The Federal Reserve has continued to raise rates in the face of a banking crisis & elevated inflation. Higher interest rates are starting to bite, particularly in the real estate sector. The homebuilder sentiment index has dropped to 30, its lowest reading since 2012. Existing home sales are at a multi-decade low. The labor market, however, remains resilient, with continued reports of low unemployment & rising wages.
A recession is not guaranteed, but the odds are higher than usual. The U.S. has avoided recession in some difficult environments, but the leading indicators & economic patterns suggest a slowdown ahead. Stay diversified, focus on the long-term, and remember that recessions have historically been part and parcel of a healthy market cycle.