May 2023 could be a good time to buy bonds, particularly in the short end of the curves in developed markets. For example, as we recently argued, 6-month US Treasuries and two-year German government bonds look attractive given the prevailing market narrative that the global central bank tightening cycle is ending. So do 2-year USTs.
However, from a longer-term asset allocation perspective, we are underweight bonds because we think the Fed will raise interest rates more than the market expects them to. This would see yields rise and prices fall.
Generally, bonds are thought of as a safe asset for uncertain times. They tend to be less volatile and less risky than stocks, and because they repay a principal at maturity they appeal to investors who wish to preserve capital. US government bonds are considered the lowest risk due to the extremely low probability of the US government defaulting, but even these are not without risk.
The Bond Yield Crash: Is It Time To Buy Now?
From a multi-decade high, March 2023 saw the biggest decline in two-year treasury yields over a three-day period since 1987. The fall came as investors flooded into government bonds following the failure of Silicon Valley Bank and the subsequent assurance from the government that it would backstop depositors.
We think markets should calm down after the volatility in March and that short-end yields will not revisit their prior peak. Traders are now betting that global central bank tightening cycle will end soon, with cuts priced for the federal funds rate in 2023. If this narrative persists, we think yields will return to their recent lows. This means now could be a good time to buy bonds, particularly 2-year DM bonds, in the short to medium term.
But what if central banks keep hiking?
Asset Allocation: Why Reducing Exposure to Bonds Makes Sense
Inflationary pressures persist in both the US and Europe. Euro area core inflation accelerated for the fourth month in a row in March 2023 to 5.7%. Meanwhile, the March CPI for the US showed no progress on disinflation as a smaller decrease in used car prices offset a slower increase in shelter costs.
Stubborn inflation keeps the pressure on the Fed and ECB to hike further. At Macro Hive, we disagree with the Fed cuts priced for 2023 and think the central bank could hike higher than markets anticipate. Were that to happen, yields could rise and prices fall. In our Asset Allocation report, therefore, we stay underweight bonds.
We prefer to overweight cash in an environment of high rates and considerable global banking risks.
What Is The Bond Market?
The bond market is a tightly-regulated market where bond investors can purchase and sell bonds of all types. The bond market can be used to buy/sell treasuries, corporate, and tax-free bonds.
How Do Bonds Work?
Bonds are essentially debt assets. They can be issued by governments and corporations when they want to raise capital. Bonds pay interest at predetermined dates, and the entire face (or par) value of the bond is paid once the bond matures.
The good thing about bonds is that many of them are highly liquid due to the large secondary market on which they can be traded. Once purchased, they do not need to be held until maturity. They can be bought or sold at will. However, their price is also not consistent, and it changes according to market demand.
The most important factor when it comes to calculating the bond price is the prevailing interest rate. When interest rates rise, bond prices tend to fall because the bond is suddenly not paying well relative to the prevailing rate. Investors compensate for this by paying less for the bond, thereby increasing its yield.
Advantages And Disadvantages of Bond Investments
Here are the major advantages and disadvantages of investing in bonds compared to some of the other major asset classes.
Bonds vs Stocks
Treasury bonds are generally considered to be safer than stocks. This is because the chances of default are very low. However, even governments can default on their debt. Bonds are also considered safer because they always pay interest, and the face value of the bond is paid out once the bond matures.
It is important to remember that corporate bonds are a different breed altogether. Since the bonds are issued by a company, the chances of default are higher. As a result, corporate bonds tend to have higher payouts compared to government issues. The riskier the financial state of the company, the higher the rate on its bond.
That said, bondholders have priority if a company does end up going bankrupt. Bondholders are paid out before shareholders, in this case, provided that the company has assets that can be used to make the payouts.
Treasury Bills vs Bonds
In the simplest of terms, it is best to think of treasury bills as short-term bonds. Treasury bills are government issued, but they mature between four weeks to a year. Treasury bills also offer a rate of return, and they are usually used by the government to fund operations.
However, the way treasury bills offer an interest rate is quite different. Bond payments are made bi-annually. Treasury bills are instead sold at a discount to their face value. Once the bills mature, the face value of the bill is paid, thereby compensating holders for the loan.
How To Buy Different Types of Bonds
Here is a look at how you can purchase various bonds we have talked about.
How To Buy Treasury Bills
The easiest way to purchase treasury bills is directly from the government. TreasuryDirect is the U.S. government’s portal for purchasing treasury bills. It can also be used to purchase various other treasury securities.
Treasury bills can also be purchased through a broker or a bank. However, do remember that offloading treasury bills are not as simple as bonds. Unless the bills are held until maturity, they can only be sold to a bank or a broker.
How To Buy Government Bonds
Government bonds are usually purchased through a broker or a bank. There are also dealers that specifically buy and sell government securities.
Although bonds are sold at auction by the treasury directly, participants are usually large financial institutions and banks.
Alternatively, one of the best ways to purchase government bonds is through a bond ETF. Although there will be a small management fee, bond funds offer a lot of diversification and relieve you of the pain of having to select which bonds to invest in.
How To Buy Corporate Bonds
Similar to government bonds, corporate bonds can be purchased through a broker, bank, or dealer.
Corporate bonds can also be purchased through funds. Many funds diversify between different kinds of bonds, stocks, and other assets, so that is another option at your disposal.
How To Buy Tax-Free Bonds
Tax-free bonds are purchased either in physical form (where holders get a certificate) or through brokers. There are not a lot of funds that offer tax-free bonds, and these bonds are usually used to achieve short-term financial goals.
Summary
Right now, purchasing bonds is not a good idea as bond returns do not compensate for the risky nature of the investments. However, a handful of bonds are still a good idea (such as the six-month US treasury bond).
Investors looking to purchase bonds can do so through a broker, bank, or dealer. However, those looking for diversified exposure to the bond market may want to consider a mutual fund or bond ETF.
Those looking to learn more about bonds and the Fed’s current strategy can take a look at the Macro Hive podcast, where Phil Suttle discusses the current state of the bond market in detail.
FAQs
→ Where To Buy Bonds?
For retail investors that are new to bond investing, the simplest way to buy bonds is through a broker. Those looking to purchase treasury bills can do so directly through the U.S. government’s portal (TreasuryDirect).
→ How To Sell Bonds
Most bonds can be sold through a broker or bank. Bond dealers are also a way of selling bonds. However, a brokerage is probably the easiest method as it will also offer bond funds and other asset classes.
→ Are Bonds Safer Than Stocks?
Bonds are considered to be safer than stocks, especially government bonds. This is because the chances of default are low, and bondholders have priority over shareholders even if the company that issues them goes bankrupt.
→ Can You Lose Money On Bonds?
Yes, bonds can increase or decrease in value. The primary factor that influences their price is the interest rate.
→ Why Bond ETFs Are Bad?
Bond ETFs are not necessarily bad. They provide a lot of diversification without requiring a lot of capital. However, going heavy on bond ETFs is probably not a very good idea in current conditions.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)
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