Common Cents & The Silver Lining

Guest Contributors: David McGrath & Sam Harris

There is simply no way to sugar coat the first 293 days of 2022 for investors. The S&P 500 is currently down just over 23% year-to-date. The major international stock index, the MSCI EAFE, is down more than 26% year-to-date. The sole economic sector with a positive return this year is Energy, and that sector only made up 2.7% of the weight of the S&P 500 as we started this year. The three “Defensive Sectors” of the market; Utilities, Consumer Staples and Healthcare have returned -13.2%, -12.0% and -12.2%, respectfully.

The most shocking return of this year, though, has been provided by the bond market. Year-to-date, the broad Bloomberg Barclays Aggregate Bond Index has returned -16.6%. Like everything else the past few years, this is very unusual. When the stock market declines, capital will typically flow out of the perceived riskier assets (stocks) to more conservative assets (bonds). This, historically, results in some of the best years of performance for bonds relative to some of the worst years for stocks. The negative correlation between the two, in regards to returns, allows for diversification for investors. As Lee Corso so colloquially coined – not so fast. Not this year, at least. When your two main asset classes have returns of -23% and -16.6%, there is no mix that produces an acceptable return for most investors.

Now, I would describe myself as a realist with a hint of optimism. This massive move in interest rates, and bond prices, may provide an opportunity for investors that it previously had not for years, or even decades. Bonds may become a productive part of a balanced portfolio – and here’s why. Most investors buy bonds for 3 reasons:

  1. To provide income
  2. As a diversifier from stock holdings
  3. To provide stability to a portfolio.

Going back to my first few years in the investment industry, the returns of the two major asset classes were generally understood. Stocks can provide a return of 8% to 10%, while bonds would return between 5% and 6%. These were total returns, which include both income generated (yield) and price fluctuation. For example, the dividend yield on the S&P 500 back in 1990 was 3.68%. If the price on the S&P 500 would increase by 5% that year, your total return would be the yield + change in price, or 3.68% + 5%= 8.68%.

The same is true for the return of bonds. The yield to maturity on the 5-year US Treasury back on 12/31/1990 was around 6.9%. If interest rates did not change for the next 12 months, the return would be 6.9%. As interest rates move down, the value of the bond goes up so the total return would be the 6.9% yield + the price increase of the bond.

Back a mere 32 years ago, a retiree looking for their portfolio to provide needed income would typically have a larger percentage of assets in bonds, and a smaller percentage in stocks. A 6% to 8% return over time was a very reasonable expectation.

Here is a chart of the yield on the 5-year US Treasury from 1990 to today. You can see the dramatic move up in the yield this year, from 1.26% to the current level of 4.45%. Remember total return for a bond is the current yield + the change in price. When you start with a yield of only 1.26%, interest rates don’t have to move up too much before the return is negative. There is a much lower margin of safety.

2022 has seen a reset of interest rates to a more normal level. From the Great Recession in 2008 to the 2020 pandemic, interest rates have been kept unusually low by the Federal Reserve. This was made possible entirely in part because that entire time inflation stayed below their 2% target. The Fed could keep interest rates low to help support the labor markets. And it worked, but at what cost?

One large effect that was not talked about very much was on those retirees that used the income provided form their investment portfolio. It was not difficult back in the early 90’s to have a balanced portfolio produce income (between stock dividends and bond interest payments) of 4 to 5%. As interest rates fell over the past 30 years, stock dividend payments also started to decline. As we started this year, the yield (or average dividend) for the S&P 500 was 1.29%. The people that “paid the price” for lower interest rates were savers. Those retirees that were able to live on a 5% income stream saw that number cut to below 2%.

In order to make up that difference, investors dependent on income would have to have more stocks in their portfolio that would supplement their lost income with capital gains from their stock holdings. One of the new sayings that was created in the investment world for the past several years was TINA, or There Is No Alternative. With income levels no different between stocks and bonds, there were fewer compelling reasons to own bonds. Most institutional money managers have been underweight bonds for the past 20 years. It has been an easy call.

That may be changing. With interest rates moving up as dramatically as they have this year, and the outlook for slower economic growth, bonds are yet again becoming investable.



Please note, nothing in this newsletter should be considered or otherwise construed as an offer to buy or sell investment services or securities of any type. Any individual action you might take from reading this newsletter is at your own risk. My opinion, as those of our investment committee Investment Committee, is subject to change without notice. Finally, the opinions expressed herein are not necessarily those of the rest of the associates and/or shareholders of Oakworth Capital Bank or the official position of the company itself.