The Impact of COVID-19 – A Dire Future for Bond Markets
The COVID-19 pandemic has made the outlook for all these factors worse. If there was a doomsday clock predicting an eventual debt reckoning, the global pandemic moved the clock’s hands significantly closer to midnight. Since the onset of the COVID-19 Crisis, the bond market has gone through three major stages:
Source: U.S. Treasury, St. Louis Fed
Stage 1: Flight to Quality (Q1, 2020)
As the coronavirus crisis broke out of China and swept across the globe, the impact on the financial markets and the world economy was severe. In the U.S. the longest economic expansion and second-longest bull market came crashing to a halt.
The S&P 500 lost over a third of its value in just over a month. In a panic, investors rushed into “safe harbor” assets like cash and Treasuries.
Yields on 3-month Treasuries approached 0% and the 10-year yield fell below 1%. Liquidity and credit quality concerns slammed corporate and high yield debt and the spreads over Treasuries spiked.
Stage 2: Stabilization (Q2-Q3, 2020)
The massive fiscal and monetary stimulus had the desired effect. Markets rallied off their lows and by early August the S&P 500 had recovered all of its losses. This coincided with the yield on the 10-year Treasury bottoming at 0.52%.
As calm returned to the markets, the spreads of investment grade and high yield corporate bonds began to narrow. In absolute terms, corporate bonds were offering less yield than they were before the crisis.
The collapse in yields throughout 2020 painted the bond market into a corner. If yields remained low, investors wouldn’t be able to generate enough income to outpace inflation. If yields started rising, the prices of bonds would fall. The stage was now set for some realized pain in the bond market.
Stage 3: Duration Damage (Q4, 2020 to present)
Investors tend to think of bonds as the “safe” part of their portfolio. Some mistakenly believe bonds won’t lose value. But Finance 101 tells us if yields rise, bonds will lose value.
This is what happened in the fourth quarter of 2020 and the first quarter of 2021. The benchmark 10-year Treasury rose from 0.52% to almost 1.75% in just over six months. During the first three months of 2021 the Barclays US Aggregate Bond index lost 3.37% and the Barclays US Treasury Long-Term index was down 13.51%, its biggest loss in over four decades.
What caused this reversal?
How Government Response Turned the Outlook from Bleak to Dire
The government’s response to the Covid-19 pandemic was simple: throw money at it. And not just some money, but a truly unprecedented amount of money. Since 2020, almost $5.5 trillion in Federal government spending has been authorized to combat the impact of the pandemic:
Source: Peter G. Peterson Foundation
In addition to the trillions dedicated to the Covid responses, the new administration is proposing a massive expansion in government spending. The infrastructure plan carries a price tag of $2.3 trillion and an expansion of educational and family-support measures comes in at $1.8 trillion. While it is unlikely these proposals will be adopted in their current form, it’s enough to make bond holders sweat.
This fiscal stimulus is only part of the equation; monetary stimulus is the other side of the coin. While the Federal Reserve has engaged in over a dozen major activities to bolster the economy, the one that stands out is a return of quantitative easing. Since the crisis began, the Federal Reserve has added $4 trillion to its balance sheet, going from $3.8trn to $7.8trn.
Simply put, no reasonable person should think such an extreme supply of debt can be issued without a corresponding impact on yields.
 Wall Street Journal, May 9, 2021, “Infrastructure Talks Could Set the Course of Biden’s Spending Plans”
Bonds are Dead Money Going Forward
The outlook for bonds is indeed looking dire, pushing advisors to look beyond traditional allocation for risk management, returns, and income. For decades the standard shorthand for a balanced portfolio was the 60% equity/40% bond model. Conventional wisdom was that the most conservative investors should have most, if not all, of their assets in bonds/fixed income.
But based upon the facts outlined above, advisors and investors should anticipate a world where bonds increase portfolio risk, rather than mitigate risk.
Allocating a significant portion of one’s portfolio to assets that are unlikely to produce a positive real return is a fool’s errand. Advisors must seek out better ways to mitigate downside risk in their clients’ portfolios.
The Time is Now for Hedged Equity
Our outlook for bonds remains bleak and the time is now for advisors to seek out alternative solutions for managing risk and addressing income needs.
Our philosophy has always been to remain “Always Invested, Always Hedged.” We have been actively managing risk since 1997, and we do it without any bonds. Through a variety of solutions, we seek to actively hedge our equity market exposure via the use of put options.
Hedging has served us well through previous market downturns, and we believe it may continue to do so in future bear markets.