As discussed in my commentary last month, volatility has continued to dominate markets. As we battle with higher inflation, rising interest rates, the next phase of the pandemic/endemic, and, as of this writing, a war between Russia and Ukraine, volatility is likely to continue for the foreseeable future.

Human life and safety are the most important focus right now. While we hope for cooler heads to prevail to minimize further casualties and overall damage, the impacts could be felt for a while. We are likely to see higher energy prices in the coming months, given Russia is the second-largest producer of natural gas (17% market share) and oil (12% market share). These price increases would add more strain to the global economy.

It should be noted, though, that in the 18 post-World War II events, the S&P 500’s sell-off, on average, was only 6.2%. If our economic situation worsens, the Federal Reserve could slow down the pace of interest rate hikes or institute stimulus measures to help offset spikes in energy prices.

The reason why volatility feels a little different than usual is that it’s impacting nearly every asset class, and many of the usual bond “safe havens” haven’t been spared. It is important to understand what is happening.

Bonds

As a refresher, a bond is a loan made by an investor to a borrower (typically a government, corporation, or municipality) in exchange for a predetermined interest rate and repayment over a specified period.

Bonds are generally considered a haven during periods of market volatility. During the 2008 financial crisis, most bonds, minus high yield, yielded positive returns during one of the worst years in stock market history.

Traditionally, people turn to bonds for current income and volatility protection. Now, after a decade of easy monetary policy and record-low interest rates, the bond market has had to quickly adjust to the notion that rates will increase more than expected.

Case in point, in November, the Federal Reserve hinted at one interest rate hike in 2022. Fast-forward three months, and the talk is now four to six interest rate hikes in 2022. Persistently high inflation has caused a change in rhetoric, and as we know by now, markets don’t respond well to drastic changes, especially those involving removing monetary policy.

This 180-degree turn has many worried that the Federal Reserve is significantly behind the curve and waited far too long to act and, because of this, bond markets have become extremely volatile. Many of those same “conservative” bonds that excelled in 2008 are struggling to start the year. It should be noted that bond markets rarely experience this much volatility in a quarter, let alone seven weeks!

While troubling, this change does not mean the sky is falling. It is important to understand why this is happening.

Credit

Most of the attention is often spent on analyzing a bond’s credit rating, as at the end of the day, a bond is only as good as its ability to satisfy its loan obligations. Generally, the lower the bond’s credit rating, the higher the interest it must pay.

As seen on the chart below, there was a massive spike in global corporate defaults in 2008 and 2009, which sparked much of the demise during the financial crisis.

Fast-forward to today, and things look much different as global corporate defaults are expected to hit a two-decade low, and the U.S. high-yield market finished 2021 with a record-low default rate of .5%!. This illustrates that the recent bond volatility is not viewed as a credit risk issue, which is a positive since a large spike in defaults is never a good sign.

Duration

Duration is one the least-talked-about topics with bonds, but it is very important. A bond’s duration measures how much its price is likely to change when interest rates move higher or lower. Bonds and interest rates have an inverse relationship: When interest rates decrease, bond values increase, and vice versa. To learn more about duration, read this BlackRock article.

Duration has been largely ignored because, in part, central banks artificially lowered interest rates for a decade-plus, which paved an easy path for bonds and put little importance on duration. This all changed when inflation took hold and is now forcing the Federal Reserve to take action via higher interest rates.

Now, with rates expected to rise over the coming years, owning a bond with a longer-term duration is not as attractive since many investors would rather own bonds that are less sensitive to interest rate increases. This is an important aspect as it does not reflect negatively on the U.S. economy, but more so is a positioning of what types of bonds to own and favoring those with a shorter duration.

Until we see several quarters of increases in default rates, much of the volatility can be attributed to the bond market repositioning and adjusting to the reality of higher interest rates. If inflation continues to remain elevated, this likely means more volatility lies ahead, but it does not necessarily equate to a full-blown credit crisis.

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