The first quarter of 2020, or, the first quarter of a new decade, will go down in history as being one of the worst quarters in market history due to a global health pandemic. This is not the kind of historic achievement we care to remember.
We know the damage COVID-19 did to global stock markets during the quarter, and if it were not for the last week of March, the quarterly score cards would have been even worse. The swift and violent decline throughout March was unprecedented, with nearly every equity asset class declining by double digits, including some bond areas like high yield and floating rate (more on them later). Other than owning Treasury bonds and cash, there was nowhere to hide.
One of the most unexpected aspects of this unpleasant first quarter is how bonds behaved. Traditionally, stocks and bonds have exhibited negative correlation, which means that when one goes down, the other goes up. That’s what makes them such a powerful team in a portfolio.
But during the first quarter, and especially in March, when stocks went down, most bonds went down with them, albeit not at the same percentage decline (thankfully!) Fortunately, some of the trouble in the bond market improved as the quarter ended, but it is worth studying and understanding what happened so investors don’t think bonds deserve a place in long-term portfolios, because they still do.
We can trace the genesis behind the decline to the middle of February, when stocks started to decline. At first, bonds were behaving in character, rising as stocks fell. In fact, for the first few weeks, between late February and early March, the bond market rose, just as I would have expected. But then, over the following week or two, as the stock market’s losses deepened, the bond market started to decline too. In all, the bond market lost nearly 9% during that period!
And if that wasn’t bad enough, certain areas of the bond market fared even worse. Between the period of mid-February to mid-March, short-term corporate bonds declined 12% and high-yield (“junk”) bonds, including floating rate/bank loans, declined nearly 20%! Even high quality (highly rated BBB or better) municipal (tax-free) bonds declined 16%. This was probably the biggest surprise. During this time, the only winners were U.S. Treasury bonds, with short-term and intermediate Treasuries up around 4%. I would have expected to see more volatility and downside in the more corporate/credit areas of the bond market (corporate investment grade, high yield, floating rate, etc.), but the declines were worse than expected.
Why Did this Happen?
There were several elements that came together simultaneously. The first one is typical of any stock market downturn, while the second and third elements are somewhat unique to this quarter’s situation:
Even in normal times, there are a number of investors who need to withdraw cash from their portfolios. These include retirees and pension funds, among other similar investors. When the stock market started to drop, these investors did the rational thing and sold their bonds instead of stocks, putting downward pressure on bond prices. We do the same thing when our clients need income from their portfolio—we partially sell the areas that have done the best—in this case, bonds, to raise cash for periodic withdrawals. This happens during our rebalancing process quite often.
When broad-based quarantines (business shutdowns, etc.) went into full effect in March, many bondholders began to worry about the impact they would have on companies and municipalities’ ability to pay back their loans and/or make interest payments. The shutdowns of businesses across the country elevated fears of defaults, or worse, bankruptcies. Whether these fears of nonpayment materialize is another question. Some of the fears are justified while some may be overblown (more bark and little bite so to speak).
Tax Law Change
The 2017 Tax Cuts and Jobs Act had the effect of raising taxes on many people, especially high-income individuals in states with high state and local taxes (think New York and California). The result was to drive many of these folks into the municipal bond market where they could earn income free of federal taxes. As a result, many municipal bond funds grew over the past few years. That was fine until the fears elevated. That caused an unprecedented stampede out of bond mutual funds forcing bond fund managers to unload their holdings at any price.
The selling pressure was literally off the charts, unlike anything I’ve seen since possibly, the financial crisis in late 2008. But even then, the bond declines such as what I saw in March took months to happen, not weeks.
I still believe despite what happened in the bond market back in March, bonds will continue to play a crucial role in providing prudent diversification benefits, including reducing volatility associated with the equity portion of portfolios and generating income. The stampede out of the more economically sensitive areas of the bond market like corporate credit, floating rate, and high yield was understandable, but possibly overdone. Bonds can be prone to panic selling just like stocks. In numerous calls with our bond fund managers, many seem to see bargains as of this writing.
It is important to keep in mind that a lot of the monetary stimulus the Federal Reserve is providing right now is already stabilizing parts of the bond market. This has been one of the reasons why they partially recovered over the past few weeks. I’m not saying the bond market is out of the woods, since nobody knows how bad this economic crisis will be or how long it will last, but the Fed’s actions have restored some much needed confidence. At the same time, as bond prices decline, yields go up, which means they produce more income. The additional higher income they generate helps to offset some of their price declines. Mutual funds are the ideal investment for this since most fund investors automatically reinvest this income to buy more shares. This compounding effect is a powerful contributor to total returns over the long term.
The investors that ran to the safer areas of the bond market (Treasury Bonds, mortgages, etc.) will have to contend with possibly poor future bond returns due to current ultra-low interest rates and below average real-returns (net of inflation and taxes). While the riskier areas of the bond market are more volatile, they may provide higher income and return.
In the end, I believe investors need to be more vigilant with their bond allocations in the coming years. With interest rates falling back to the lows we saw during the global financial crisis, it is going to be more challenging for bonds to generate positive total returns. Therefore, it may make sense to have exposure to a variety of bond types, including even some of the riskier areas of the bond market, to achieve your longer term investment objectives.