INVESTORS depend on bonds to achieve a balanced and resilient investment strategy. They offer a predictable source of income and capital preservation while diversifying equity risk amid economic downturns.
In 2022, however, during one of the steepest equity drawdowns in recent memory, bonds failed in their role as an equity hedge. The S&P 500 Index lost 24 per cent from its peak in December 2021 to reach a trough in September 2022, while a balanced “60/40” portfolio (60 per cent equities and 40 per cent bonds) lost 19 per cent – less damage, but not by much.
In previous US equity drawdowns, the same allocation to bonds would have easily cut the drawdown loss by half.
What happened? Can investors still rely on US Treasuries as a hedge for their risk exposure?
Bonds not only provide a ballast to a diversified portfolio, but also continue to serve as a useful hedge against equity risk – in most circumstances and especially over longer holding periods.
In other instances when US equities collapsed, positive bond returns prevailed: the 1973 stagflation; the early 2000s recession and bursting of the dotcom bubble; and notably between 2008 and 2009, during the global financial crisis. In all these cases, bonds were well-positioned to hedge major equity drawdowns.
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However, in 1994, both US Treasuries and equities sold off in tandem.
Aggressive monetary tightening in 1994 and 2022
The “Great Bond Massacre” of 1994 is one of the most significant events in bond market history, in which over US$1 trillion was wiped out in global bond values. While historic at the time, the magnitude of losses was significantly surpassed by the bond rout of 2022.
In both events, the sharp and unexpected tightening of monetary policy by the US Federal Reserve served as the trigger.
At the start of 1994, the Fed initiated a series of interest-rate hikes to avert any potential upsurge in inflation arising from a robustly growing US economy. The rate hikes took investors by surprise, particularly considering such well-behaved inflation. Bond prices fell sharply as yields spiked higher.
Similarly, in 2022, the Fed commenced a tightening cycle at an unprecedented pace that again shocked the market.
Unlike in 1994, the catalyst was an exceptional surge in inflation. After several decades of relatively low and stable inflation, the US experienced a sharp spike in the pace of price increases in 2021. The annual inflation rate peaked at 7.2 per cent in June 2022, the highest level since 1981.
Inflation surged due to a combination of factors, including pandemic-related supply chain disruptions, alongside fiscal and monetary stimulus, which put upward pressure on wages and prices. Rising prices of food and energy added meaningfully to inflation.
The Fed responded with one of the most aggressive tightening cycles in its history. The federal funds rate increased from near zero in March 2022 to over 4 per cent by the end of the year, a total change of 425 basis points in just nine months. Ten-year US Treasury rates rose nearly in lockstep.
It was one of the worst-ever years for bonds. The Bloomberg US Aggregate Bond Index fell by about 13 per cent, its largest annual decline since its inception in 1976. Long-duration bonds were particularly hard-hit, as their prices are highly sensitive to interest-rate changes. Some long-dated US Treasury bonds lost more than 20 to 30 per cent in value.
In both 1994 and 2022, the bond market rout spilled over into the US equities market, which started each tightening cycle at lofty valuations, around the highest ranges on record.
In 2022, equity earnings yields were comfortably well above bond yields. But as bond yields rose, they began to offer a more compelling investment option, triggering some rotation out of stocks as investors sought to lock in higher rates in fixed-income markets.
The S&P 500 Index fell nearly 20 per cent in 2022, marking its worst annual performance since 2008. The Nasdaq Composite Index, heavily weighted towards technology stocks, dropped by more than 30 per cent.
Implications for investors
Over a relatively short 12-month horizon, investors may need to assess the reliability of traditional 60/40 portfolios, as bonds may not offset equity losses under certain circumstances. Rapid monetary policy tightening, elevated equity valuations, and low bond yields can signal a higher risk of bonds falling short as a hedge.
However, US yields have moved meaningfully higher since 2022, establishing a significant yield buffer to help mitigate any potential bond losses.
Moreover, for investors with a horizon greater than 12 months, history shows that bonds have fulfilled their hedging function. Negative equity returns over three years, for example, have consistently corresponded with positive performance in bonds.
Over even longer horizons (10 years is the suitable term for a strategic allocation), bonds contribute meaningfully in helping to avert portfolio drawdowns.
A portfolio invested 100 per cent in equities posted an average 10-year annualised return of just under 12 per cent since 1973; the worst 5 per cent of 10-year periods showed a minus 1 per cent loss. Diversifying 20 per cent into bonds reduced the tail risk of loss, with a 100-basis-point cost to annual performance.
Investors’ risk preferences will determine where they sit in a continuum, balancing the pursuit of returns while dampening the tail risk of loss.
The writer is chief portfolio strategist at Bank of Singapore