Bonds, A New Risk/Reward Paradigm?

While there has been significant market stress and negative news, the markets have held up reasonably well.  We will have a more thorough review of equity investments next week after seeing some key earnings reports.  In the meantime, we wanted to briefly update you and focus on what we see are significant opportunities in fixed-income markets (bonds).

As measured by the S&P 500, the U.S. stock market had a good first quarter and is up around 8% at the time of this note.  The return is driven by a few technology stocks like Apple, Microsoft, and Amazon, which dominate the NASDAQ (up 20% year-to-date) and heavily influence the S&P 500 due to their exceptionally large valuations relative to other stocks.  This sounds great, except for two overriding facts.  First, the NASDAQ is still about 18% below its January 2022 high.  Second, the price of most stocks on the NASDAQ has been declining.  A few huge stocks performing well may not be sustainable in lifting markets as a whole.  We will be able to comment further as key first-quarter earnings reports continue in the next week, which so far have been mixed to negative.  We continue to feel value stocks offer greater risk-adjusted opportunities as technology companies have more downside risk if earnings and revenue expectations fall short.

We have commented on the collapse of Silicon Valley Bank (and others) in previous communications.  Since financial companies are usually part of value investing, we adjusted portfolios to reflect increased risks to banks as customers move money from low-interest checking and savings accounts to higher interest-bearing investments.

 Short-Term Fixed Income

Rates on 6-month CDs have reached 5%, and money markets are paying over 4%.  It makes sense (it pays) to manage cash balances in this environment.  It is easy to do with accounts electronically linked to our checking account.  We have mentioned before there are pooled CD accounts with daily liquidity paying well over 4% with FDIC protection up to $20 million.  For safe and readily available funds, you have to go back to 2007-2008 to find the last time rates were anywhere near this attractive.

When rates initially started their increase, I-Bonds were very attractive.  For those who purchased these bonds in the past year, the next 6-month reset will occur May 1 and is expected to be 3.8%.  If inflation and short-term interest rates continue to fall, I-Bonds become less attractive relative to alternatives.

Bonds

Investing is always a balance between potential return and the risk you take to get that return.  With the rate of inflation declining and expectations that it may continue to do so (as reflected by declining rates in the table below), the downside risk to investing in bonds today is much smaller than the expected forward return.  We have been experiencing an inverted yield curve, which simply means short-term rates are higher than long-term rates.  There are two interesting ramifications.  First, inverted yield curves often signal a recession and indicate more market sell-off risk.  However, timing is tricky, and some stock sectors do well even in recessions.  The second which represents an opportunity is in bonds.  Inverted yield curves signal the potential outperformance of bonds when the one-year treasury yield peaks.  The last five times this happened (1980, 1981, 1989, 2000, 2006), bonds outperformed cash-equivalent investments by wide margins.  It is our opinion we are in one of those periods.  Like stocks, the bond markets have sectors.  For instance, owning bonds investing in office building mortgages carries a high degree of risk.  However, we do not have to take significant risks to get a decent return in this asset class.

Summary

We are in a very interesting market transition with both opportunities and significant risk.  Next week we will update our current stock market views.