How inflation fears led to a historic global bond rout


The bond market in the United States and other wealthy countries has long been boringly predictable, with generally steadily rising prices and much milder volatility than in the most talked about stock market. The inflation that took hold as economies recovered from their pandemic meltdown changed all that, driving the biggest drop in global bond prices in at least three decades. The rout is forcing a rethink of the frameworks that have long governed investment in the $100 trillion field.

1. Why is inflation so bad for bonds?

For two reasons. A bond is a contract providing for a series of fixed payments over time. The right to collect these payments is less valuable if inflation is expected to erode their purchasing power. The other reason has to do with the central bank’s traditional response to inflation: raising interest rates, a move designed to slow economic activity by making borrowing more expensive. A rise in interest rates has the secondary effect of reducing the resale value of existing bonds. Indeed, when bonds with an interest rate of 3% start to arrive on the market, traders will pay less for bonds paying 2%. Prices can start falling even at the first hint that a central bank might be considering a hike.

2. What happened?

Bond prices peaked at the start of 2021, then began to decline as inflation began to soar. This fall accelerated when it became clear later in the year that the price increases were not transitory, as the US Federal Reserve had first predicted. Then, in early 2022, a number of factors further heightened inflation fears, including Russia’s invasion of Ukraine, sanctions imposed by the United States and the European Union in response, and a new series of closures caused by a pandemic in China. In March, the Fed launched what officials said was a series of significant interest rate hikes. As of June 14, the Bloomberg Global Aggregate Index, a measure of corporate and government bond total returns, had fallen 19.7% from its peak.

3. How important is this?

While that may not seem like much in the most volatile equity markets, it was the so-called record-breaking biggest drop in the bond market dating back to 1990. By one estimate, 2022 looks set to be the worst year for US bonds since 1842, when the nation is mired in an economic and financial crisis. Interest rates had been on a downward trend since the early 1980s when the Fed brought double-digit inflation under control, meaning bond prices had been in a seemingly endless bull market ever since. . That rally had been supercharged more recently by the massive central bank response in 2020 to the economic toll of the pandemic, when the Fed cut rates to near zero.

4. Is inflation the only problem?

No. As the world’s largest central banks began or prepared to tackle inflation by withdrawing economic stimulus, concerns grew that the effort could tip some countries into recession. Bond investors have a somewhat different view of downturns than most people. On the one hand, bad times lead to more defaults, which is bad for lenders. On the other hand, interest rates typically fall during recessions, which means bond prices often rebound. Closely watched parts of the U.S. yield curve, often hailed as harbingers of economic downturns, have inverted in recent months.

5. Where did this leave investors?

In an unusually tricky place. In many portfolios, bonds are valued for stable income streams, for their lack of volatility, and because they can generally be counted on to move in the opposite direction of the stock market. These last two features haven’t held up recently. An investor who had a 60/40 portfolio, the classic risk-aversion strategy named after his share of high-quality stocks and debt, has seen his value fall by a fifth this year, from mid -June. In the short term, traders had to decide whether low prices were tempting – themselves a bet on the likelihood of inflation peaking soon. Others still recommended that investors reduce their bond holdings, expecting inflation to remain at historically high levels even if a peak was reached. In this case, long-term yields could rise further as investors demand greater compensation for lending over a longer period, inflation eating away at their yields.

6. What does this mean for borrowers?

Rising interest rates will likely weigh on economic growth. In the United States, the effect of more expensive mortgages could be seen in the month after the Fed’s first hike, as sales of new single-family homes fell to their lowest level since the pandemic shutdowns began. in 2020. And businesses, especially those with poor credit ratings, will find it more costly to take on debt. As the days of easy money provided by central banks came to an end, borrower creditworthiness returned to normal importance in the bond market.

• Bloomberg articles on the poor performance of corporate bonds as inflationary pressures increase; the Fed’s difficulty achieving a “soft landing” as it hikes rates.

• A 2018 opinion piece by Ben Carlson, director of institutional asset management at Ritholtz Wealth Management, on how bear bond markets aren’t measured by losses alone.

• An introduction from Pacific Investment Management Co. on bonds and the impact of inflation on fixed income returns.

• The investment outlook archive of former bond king Bill Gross, with essays discussing the implications of inflation for asset allocation.

• An Odd Lots podcast interviewing Macquarie Capital strategist Viktor Shvets on the risk of central banks raising rates too quickly and pushing the world into a recession.

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