Bonds: The Canary in the Coal Mine
Have you heard the expression about the canary in the coal mine? Canary birds were the first to react to unhealthy conditions in coal mines and served as a warning to the miners. Bonds can also be like those canaries, warning investors of a coming recession.
As stocks were experiencing 5%+ daily swings in March, bonds were also going through a period of significant price changes. There was a mismatch between liquidity seekers (sellers) and liquidity providers (buyers). With sellers overwhelming buyers, prices fell on most bonds, even relatively safe municipal bonds and high-quality corporate bonds.
Why Do We Care
Under normal economic conditions, long-term bonds generally pay a higher interest rate than short-term bonds. Because an investor assumes more risk with a long-term bond, the higher interest rate is justified and expected. When economic conditions are not normal (for example, more sellers than buyers) and long-term bonds have lower yields than short-term bonds, that is referred to as an “inverted yield curve” and often warns of a recession. In 2008, the mortgage market began going through an upheaval before the stock market fully recognized the magnitude of the financial crisis.
The bond market is a source of important liquidity. It greases our economic engine and makes it possible for many transactions to take place. When liquidity dries up, the economic engine could break down, and problems can ensue. So when liquidity was virtually non-existent in March of this year, it was worthy of a few canaries.
The Federal Reserve Steps In
Fortunately, the Federal Reserve stepped in. Within a matter of days, the Fed lowered interest rates back to near 0%. It also announced plans to purchase debt on the open market and support money market funds. In addition, it provided a backstop that helped reassure the markets that enough liquidity had been added to the bond market. All of this helped the economic engine operate more smoothly.
Since then, the Fed has purchased bonds and increased its balance sheet by trillions of dollars. Their willingness to step in this past March and their continuing significant presence is providing confidence to the markets that liquidity will be available. As a result, bond prices have improved since their March lows. However, the improvement has slowed of late, due to another issue that is becoming important.
Looking Ahead – Fundamentals Matter
The Fed’s actions help on the liquidity side. As we begin to move forward, fundamentals matter. Meaning, the ability of borrowers to meet their payment obligations has moved to the forefront. Look at the real estate market. If you own rental properties, you depend upon renters to make good on their promises to pay rent. If rental income goes down, your cash flow suffers. If you do not have a mortgage, you might be fine.
However, if a mortgage was needed to fund the purchase of the property, you might need to access cash from other sources to make good on your obligation. Can you access that cash?
The holder of your mortgage recognizes there is now a higher risk of not receiving monthly mortgage payments. Greater risk means lower mortgage values. This is happening across the bond market. Be it with corporate bonds, real estate debt, municipal bonds, or foreign bonds. The borrower’s fundamental creditworthiness has likely declined, and the prices of their bonds have followed lower. Essentially, only U.S. Treasuries have seen bond prices hold steady during this pandemic.
Know What You Own
Owning only U.S. Treasuries means locking in yields that are probably less than 1%. Holding other bonds will likely result in higher yields but with higher credit risk. As a bond investor, it is important to know what types of bonds you own, what types of risks you are taking, and make sure you are comfortable with what you own.
As the pandemic plays out, investors will be able to evaluate the credit worthiness of municipalities and corporations. As more information becomes available, bond prices will react as the fundamentals of their issuers change. The effect can be good or bad. You will want to continue to evaluate the bond market. As information changes, you should be ready to make changes to your portfolio in order to take advantage of opportunities or move away from risks.
Bill Wendling, CFA, is a Senior Portfolio Manager with Bedel Financial Consulting, Inc., a wealth management firm located in Indianapolis. For more information, visit their website or email Bill.