The Bloomberg Global Aggregate Index, a benchmark for the bond market worldwide, has tumbled 11% from its peak in January 2021, equating to a drop of $2.6 trillion in the index’s market value. Bloomberg News describes this as an unprecedented loss in the long history of the bond market. Big capital losses are always bad news in the stock market, but in the bond market can be welcome news for most.
One important reason is lower bond prices mean higher bond yields. Investors who hold bonds for income are pleased when their prices fall, because those bonds continue paying the same income as before. Plus, the new bonds they purchase as older ones mature pay higher income. Investors who hold bonds for capital appreciation need to look at their portfolio duration, 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 decline if they expect to be in bonds for more than 7.35 years, because the additional yield their earn in the future more than offsets the immediate capital loss. On the flipside, they are unhappy if they expect to remove bonds from their portfolio sooner than 7.35 years.
The vast majority of bond investors are either income investors or expect to be in bonds indefinitely. The exceptions are those using bonds as a moderate-risk investment saving for medium-term expenses, such as college or a down payment on a house, and market timers who get in and out of bonds for short-term capital gains. I have no idea how much the latter group represents of the $2.6 trillion, but I’ll throw out $100 billion as a guess as good as any other. If so, the other $2.5 trillion represents investors happy about the loss. And if you weren’t in bonds up to now, but are scared due to the losses, you’re thinking backwards. You can enjoy all the benefits of higher yields without having to suffer the capital loss borne by existing bond investors.
There’s more good news. The $2.6 trillion is a theoretical calculation for U.S. dollar-based investors who track the global index without a currency hedge. Most of the loss came from an appreciation in the dollar against the currencies of the non-U.S. bonds in the index. Since the August peak of the index, the dollar is up almost 8% versus the euro and 6% versus a basket of currencies weighted by share of the index. Investors who hold hedged versions of the index, or non-U.S. investors, lost about 5%, rather than the 11% of unhedged dollar-based investors.
Think about what it means for a U.S. investor who holds unhedged foreign bonds if the dollar strengthens. A stronger dollar means the investor’s dollar-based wage and other investment income buys more on global markets. It also reduces expectations of future inflation, because a stronger dollar means cheaper imports, which puts downward price pressure on domestic producers as well. That makes all dollars, and all dollar-based nominal investments, more valuable in terms of purchasing power.
Against those gains, the investor will lose because the income from foreign bonds — unchanged in nominal terms — will buy fewer dollars. However, unless a dollar-based investor has a massively unbalanced portfolio tilted toward unhedged foreign bonds, the gains from a stronger dollar are likely larger than the losses. So, the investors suffering the full 11% nominal loss from the index decline are likely better off overall as a result.
Finally, we can’t talk about bonds without mentioning inflation. Much of the decline in the Bloomberg Global Aggregate Index was caused by rising yields on U.S. Treasury securities 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 increased, but not as much as in the U.S. But the rate on Treasury Inflation-Protected Securities is up only 0.81 percentage point, and that’s a better gauge of the real rate of return investors can expect to earn. Much of the decline in nominal price of bonds is offset by reduced 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 rates on bonds corroborate — that the recent and expected future rate increases by the Federal Reserve will bring slow inflation to the long-term benefit of bondholders. There is a nightmare scenario for bonds in which the Fed cannot control inflation, leading to steep price declines in bonds and sharply reduced purchasing power of the income generated by bonds. But this is a feared future loss, not the past loss. And if you fear it, unhedged foreign bonds are an attractive option, as perhaps other countries’ central banks will be more successful than the Fed.
Bondholders as a group should celebrate the $2.6 trillion loss -- and wish for more.
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