One important reason is that lower bond prices mean higher bond yields. Investors who hold income bonds are pleased when their prices fall, because those bonds continue to pay the same income as before. Also, the new bonds they buy as the older ones mature pay higher income. Investors holding capital appreciation bonds should consider the duration of their portfolio, which is 7.35 years for the Bloomberg Global Aggregate Index. What this means is that investors who care about total return are happy when bond prices go down if they expect to be in bonds for more than 7.35 years, because the extra return they get down the road more than offsets the immediate capital loss. On the other hand, they are not happy if they expect to remove the bonds from their portfolio before 7.35 years.
The vast majority of bond investors are income investors or expect to be in bonds indefinitely. The exceptions are those who use bonds as a moderate-risk investment savings for medium-term expenses like college or a down payment on a house, and market timers who move in and out of bonds for capital gains at short term. I have no idea how much this last group of $2.6 trillion represents, but I’ll throw out $100 billion as as good a guess as any. If so, the other $2.5 trillion represents loss-happy investors. And if you weren’t tied up until now, but you’re scared of losses, you’re thinking backwards. You can enjoy all the benefits of higher yields without having to suffer the principal loss that existing bond investors endure.
There is more good news. The $2.6 trillion is a notional estimate for US dollar-based investors who follow the world index without a currency hedge. Most of the loss came from an appreciation of the dollar against the non-US bond currencies in the index. Since the index’s August peak, the dollar is up almost 8% against the euro and 6% against an index share-weighted basket of currencies. Investors holding hedged versions of the index, or non-US investors, lost about 5%, versus 11% for unhedged dollar-based investors.
Think about what it means for a US investor holding unhedged foreign bonds if the dollar strengthens. A stronger dollar means that the investor’s dollar-based salary and other investment income buys more in global markets. It also lowers expectations of future inflation, because a stronger dollar means cheaper imports, which also puts downward pressure on domestic producer prices. That makes all dollars, and all nominal dollar-based investments, more valuable in terms of purchasing power.
Against those earnings, the investor will lose because foreign bond earnings, unchanged in nominal terms, will buy fewer dollars. However, unless a dollar-based investor has a hugely imbalanced portfolio tilted toward unhedged foreign bonds, the gains from a stronger dollar are likely to outweigh the losses. Therefore, investors who suffer the full 11% nominal loss from the index decline are likely to be better off overall as a result.
Finally, we cannot talk about bonds without mentioning inflation. Much of the decline in the Bloomberg Global Aggregate Index was due to rising US Treasury yields as inflation accelerated. The yield on the seven-year note, for example, rose from 0.95% in August to a recent 2.36%, an increase of 1.41 percentage points. Yields in Europe and other developed economies also rose, but not as much as in the US. But the rate on Treasury inflation-protected securities rose only 0.81 percentage point, and that’s a better indicator of the rate. of actual return that investors can expect to earn. Much of the fall in the nominal price of bonds is offset by lower expectations of future inflation.
Of course, that still leaves bond investors with a significant loss in value. But most investors expect—and market indicators such as breakeven bond rates bear this out—that recent and expected future rate hikes by the Federal Reserve will bring slow inflation to the long-term benefit of investors. bond holders. There is a nightmare scenario for bonds in which the Fed is unable to control inflation, leading to sharp declines in bond prices and a sharp reduction in the purchasing power of bond income. But this is a feared future loss, not the past loss. And if you’re afraid of it, unhedged foreign bonds are an attractive option, since other countries’ central banks may be more successful than the Federal Reserve.
Bondholders as a group should celebrate the $2.6 trillion loss and wish for more.