Why the Bond Market Turned Bearish After a Decades-Long Bull Run

(Bloomberg) -- For decades, the bond market was mostly a one-way street: Prices kept going up as borrowing rates went lower, even sending yields negative in some places. But now the opposite is happening: bond returns are falling the most on record as yields surge. Investors are scrambling to sort through the impact of the inflation that's come in the pandemic's wake, questions about how fast central banks will hike interest rates to damp price pressures and worries about what those hikes will do to growth. Plus, the war in Ukraine has added a new layer of uncertainty.

1. What's been happening?

Interest rates had been on a downward trend since the early 1980s, meaning bond prices had been in a seemingly endless bull market. That rally was supercharged by the massive central bank response in 2020 to the pandemic's economic toll, when rates fell to record lows. But since the pandemic started receding, global bonds have been under pressure. The Bloomberg Global Aggregate Index, a measure of corporate and government bond returns, has fallen around 12% from its peak in early 2021. While in more more volatile asset classes such as equities that kind of swing might not sound like a huge deal, in the case of global bonds it's the largest drawdown on records going back to 1990. In recent months, the sell-off has gathered more steam.

2. What does that figure mean?

The index measures total returns, which looks at both the interest paid on the bonds as well as the price of the security. Bond prices have been falling because investors are demanding a higher yield to buy them (bond prices and yields have an inverse relationship), so the index has plunged. If you're a buy-and-hold investor, the price of your bonds doesn't matter as much since you don't intend to sell. But for anyone trading their bonds, the drop in value is a problem.

3. What's behind the recent rout?

The market really started going downhill in January because of signs that the U.S. Federal Reserve, as well as other central banks, were coming round to the view that the pandemic-fueled inflation wasn't going to be as transitory as they had hoped. Russia's invasion of Ukraine has exacerbated worries about price pressures, both from the disruption of already fragile supply chains and through the sanctions imposed by the U.S., the European Union and other countries against Russia. Historically, wars often encourage people to buy bonds because they're seen as less risky investments,. But the current conflict's inflationary impact was seen as such that debt still sold off. Sure enough, the Fed hiked rates in March as the war raged.

4. Why does the bond market care so much about inflation?

Fixed-income investors rely on a steady stream of fixed payments over the lifecycle of the bond. Inflation erodes these returns as prices rise more broadly in the economy, lessening purchasing power. If a bond is held to maturity, the principal received then will be worth less than if inflation had stayed low.

5. Then why are rate hikes also creating worry, if they help damp inflation?

An increase in the short-term interest rates managed by central banks -- such as the Fed Funds Rate in the U.S. -- means that investors will need to demand greater compensation for holding bonds over a longer period. Investors try to pre-empt rate rises by selling bonds before the hikes even begin, which has been a factor in the early 2022 rout. Further out, there are also concerns that a swift series of hikes could cause a recession.

6. What does this mean for investors?

Investors are finding themselves in a tricky spot. Low prices can make getting back into the debt markets tempting for those who see inflation peaking soon. Others, including BlackRock Inc., are still underweight bonds, expecting that the pace of inflation will drive up long-term yields further. That would make inflation-protected securities such as TIPs, which have payments linked to the inflation rate, more attractive.

7. How about for businesses and consumers that need to borrow?

Rising interest rates will likely take a toll on growth, especially for interest-rate-sensitive sectors like housing. U.S. homebuyers are confronting mortgage rates that are rising at the quickest pace in three decades, a heady acceleration that may give some prospective owners pause. And companies will find it more expensive to raise debt in the public markets, with global credit spreads reaching the widest level since mid-2020 in March.

The Reference Shelf

Bloomberg stories on the poor performance of corporate bonds as inflation pressures mount; the difficulty facing the Fed in achieving a “soft landing” as it raises rates.
A 2018 opinion piece by Ben Carlson, the Director of Institutional Asset Management at Ritholtz Wealth Management, on how bond bear markets aren't measured by losses alone.
A Pacific Investment Management Co. primer on bonds and the impact of inflation on fixed income returns.
The investment outlook archive of onetime bond king Bill Gross, with essays addressing the asset allocation implications of inflation.
An Odd Lots podcast interviewing Macquarie Capital strategist Viktor Shvets on the risk that central banks raise rates too quickly and flip the world into a recession.