While any negative performance can be difficult, negative fixed income returns can feel particularly shocking. Year to date, many bond funds are down. However, declines within the bond market are not unprecedented.
Sometimes people think of bonds as investments that will never have negative performance, but that is not the case. To enjoy the potential rewards of investing in bonds, investors must take on some risk.
Exhibit 1 illustrates rolling 3 month returns of the Bloomberg U.S. Aggregate Bond Index.
It may be surprising to see that 3‐month periods in which returns for this index have been negative are not uncommon.
However, by expanding the time horizon to 12 month rolling periods in Exhibit 2, we gain Going back to 1976 (as far back as we have data for this index) there are far fewer negative periods. While this won't match the exact experience of investors, it shows the power of a long‐term approach. No one can predict what will happen moving forward but having a plan you can stick with may help in short‐term periods of volatility.
Tune Out the Noise ‐ With Fed officials signaling a more hawkish policy stance1, some market participants might choose to switch to cash or shorter‐duration bonds. However, the analysis in Dimensional’s recently published article, All Eyes on the Fed? A Look at Federal Funds Rate, Bond Return, and Term Premium, does not support the idea of allocating towards cash or shortening duration in response to changes in the federal funds rate. The timing and direction of changes to the federal funds rate is difficult to predict and doesn’t indicate how other interest rates and market participants will react.
Use Information in Bond Prices ‐ Bond prices reflect the aggregate expectations of market participants. Investors can rely on current term spreads, the yield difference between longer duration bonds and shorter duration bonds, for information about expectations of returns. Research shows that current term spreads reliably forecast future term premiums.2 A systematic strategy that dynamically varies its duration and currency allocation based on current term spreads across yield curves is a robust way to target higher expected returns in fixed income.
Tax Loss Harvesting is a potential action item. During market downturns, clients may want to manage tax liabilities through loss harvesting opportunities. Certain clients may choose to sell to realize capital losses, which they may use to offset current or expected future capital gains.
Stay Invested ‐ To potentially enjoy the benefits of higher expected returns, investors should be willing to accept increased uncertainty. A key part of a good long‐term investment experience is being able to stay with your investment philosophy, even during tough times. A thoughtful, transparent investment approach can help investors prepare to face uncertainty. This may improve their ability to stick with their plan, tune out the noise, and potentially capture the long‐term returns the capital markets have historically provided.
1Jeff Cox, "Fed’s Bullard says the central bank’s ‘credibility is on the line,’ needs to ‘front‐load’ rate hikes," CNBC.com, February 14, 2022.
2Please see the following papers on the relation between current term spread and future term premium:
Eugene F. Fama, "The information in the Term Structure," Journal of Financial Economics 13.4 (1984): 509–528.
Eugene F. Fama and Robert R. Bliss, "The information in Long‐Maturity Forward Rates," American Economic Review 77.4 (1987): 680–692.
John H. Cochrane and Monika Piazzesi, “Bond Risk Premia,” American Economic Review 95.1 (2005): 138–160.
Past performance is no guarantee of future results.
Dimensional Monday Moves: Update on Topical Resources 3/28/2022