Bonds beyond the borders

Terrible start to the year for bonds, which are showing extreme performances beyond all historical statistics.

Inflation messes up interest rates

The term inflation has been on everyone’s lips since the beginning of the year. Shortages of products such as oil or flour, dizzying growth in others or longer delivery times, investors are beginning to realize that a new world is arriving. Evidence of this is that the word “inflation” is the first searched word on Google this month May 2022. The purchasing power of households becomes the focus of interest.

Search Google for “inflation”.

Source: Google Trends, XO Investments AG

The consumer price index reflects this situation. The United States exceeds 8%, this number is similar for Europe. At 2.4%, Switzerland recorded its highest level in 15 years. This turnaround takes us back to the 1970s, a time of great inflation. And that is not without consequences for interest rate developments.

US and CH inflation

Source: Bloomberg, XO Investments SA

All global bond markets are under pressure from central bank announcements and inflation numbers being released in different countries every month. Whatever the market, performances are mostly negative in a strong bearish move. Bond indices lose between -8% for Switzerland and -14% for global credit or emerging markets.

development of the bond market

Source: Bloomberg, XO Investments SA

The SBI index, which has long had a negative yield-to-maturity, is back above 1% with a spectacular rise. The average duration fell slightly to under 7 years. The market is therefore completely disrupted by these new economic configurations.

Duration and Yield to Maturity SBI

Source: Bloomberg, XO Investments SA

Credit less affected than long maturities

All segments of the SBI are largely negative. Even as credit suffers from expectations of a slowdown, very good quality long bonds have been hit hardest by rate tightening. The 7-year Swiss government domestic segment declined more than 10% for the year.

Performance of the SBI segment

Source: Bloomberg, XO Investments SA

Credit spreads, i.e. the difference in yield between a credit bond and a government bond, are increasing. But that stress is much less important than it was during the Covid lockdown. Both investment grade and high yield bonds in Europe see spreads widening to 80 and 400 basis points respectively.

European investment grade spread

Source: Bloomberg, XO Investments SA

Spread High Yield Europe

Source: Bloomberg, XO Investments SA

Losses beyond statistics

The losses since the beginning of the year are statistical records. If you look at the maximum drawdowns of all major bond indices, i.e. the extreme losses between the high and low points of the crisis, we are surpassing all historical values.

US Treasury bond performance exceeds the 10% loss and is well above what was recorded in the stagflation years of the 1970s. The SBI (Swiss bond index) had never recorded a loss of more than 10%.

Drawing of US Treasury bills

Source: Bloomberg, XO Investments SA

Drawdown SBI

Source: Bloomberg, XO Investments SA

The conclusions are identical for the global “investment grade” indices or for European government bonds. All markets experience extreme bear situations in a very short period of time.

The current situation is even more extreme when we consider that bonds, but also stocks, are in a phase of massive losses. Rarely have the two asset classes developed so negatively at the same time.

Decline in the US market

Source: Bloomberg, XO Investments SA

We can go further in this analysis by comparing the performance of US equities and the high yield bond index. There seems to be a non-statistically significant relationship between these two variables.

Link between equities and high yield bonds

Source: Bloomberg, XO Investments SA

In fact, correlation is becoming increasingly important. The correlation since 2000 is 68%. Using 2013 data, it increases to 74%. Finally, if we examine the performance of high yield stocks and bonds since 2019, we see an 81% correlation. So the diversification principle decreases over time.

This phenomenon is identical when we compare stocks to a global bond index, whose correlation increases from 39% between 2000 and 2022 to 67% since 2019.

This observation is likely related to the massive liquidity injections by central banks.

An expected up cycle

The financial markets always anticipate, and the current crisis is no different. The Fed’s speeches are under scrutiny from all actors adjusting their rate expectations in line with the Fed’s stated desire to raise rates quickly.

However, the market now appears to be pricing in more rate hikes than Federal Reserve members are willing to believe. This appears to be what the chart below conveys to us, with market interest rates above the Fed members’ reported averages.

US Interest Rate (%)

Source: Bloomberg, XO Investments SA

The market therefore appears relatively extreme in its forecasts. The negativism of all markets, especially bond markets, is at an unprecedented level.

It therefore seems reasonable to us not to foresee further extremes. As interest rates have risen, the difference between stock and bond yields is normalizing. Bonds are beginning to become more attractive again, with bond yields approaching stock dividends and reaching absolute levels that are becoming attractive to an investor looking to take on little risk while earning a decent yield. Should inflation eventually stabilize, interest rates would undoubtedly pause to partially recoup 2022’s losses.

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