Bond investors get emotional

Interest rate pressures have impacted traditional bond investments over the past year, with the benchmark Bloomberg U.S. Aggregate Bond Index delivering negative returns over the past year. In the 45-year track record of the Index, negative annual returns occurred in just four of those years, and never back-to-back. Through February 10, the Index has returned -4.1% for the year-to-date, signaling another monthly loss for February (barring a dramatic turnaround) and potentially the worst on record. This is due to rising interest rates (the 10-year Treasury yield climbed 51 basis points since the start of the year), modest widening of credit spreads, and a low absolute level of yield that provides little return protection against negative price moves.

The impact to investors from negative returns is even more severe when measured on a “real” basis, given the elevated level of inflation. Investors in this space have seen their purchasing power severely compromised. This could cause emotional selling, given that there have been substantial inflows into bonds over the past five years. This trend is showing signs of shifting, with net outflows from investment grade and high yield funds in each of the last five weeks. Bond ETFs saw their first outflows in more than five years in January (excluding a shock in March 2020 from the pandemic), losing $1.5 billion during the month after attracting $27.3 billion in inflows in December. High-yield ETFs saw outflows of $7.6 billion, the largest loss on record.

This is meaningful because it reflects that some of the emotional decision-making we normally see in the equity market is transitioning to the bond market. If this continues, it could exacerbate losses, as managers of funds and ETFs will need to raise liquidity, which continues to increase selling pressure. Given that yield remains a priority for investors, we could see a shift to dividend-focused equities, credit-sensitive bonds, options-based strategies, and annuities with downside protection.