Inflation, recessionary fears, and the trajectory of monetary policy at the federal reserve have all moved fixed income markets this year. What is the bond market telling us about the path forward? Where do we go from here? Watch this 25-minute video to find out.
August 16, 2022 at 12:00 P.M. E.T.
Daniel Dusina 00:09
All right, well, we're at almost two past 12 P.M., so I think we should get things started here. Welcome, everybody. Thank you very much for joining. As you may or may not know, we at Blue Chip Partners have been putting on these live webinars for the past few months, hoping to give all of you guys some timely and evergreen information on the world of investment management and financial planning. Before we jump into things today, just a couple of housekeeping items. Number one, this meeting is being recorded so that anyone who would have liked to join but was not able will be able to watch the replay as it will be posted to our blog. Make sure you like and follow us on LinkedIn to get all the latest content, such as these webinar replays, as well as other investment management and financial planning-related topics. And then finally, let's make this interactive. If you have any questions, feel free to use the Q&A function at the top bar, as well as the chat function. Time permitting at the end, we'll look to address any questions that you all may have. Before we jump into things, a couple of quick introductions. My name is Daniel Dusina; if I haven't met you already, I'm the director of investments here at Blue Chip Partners. I am joined by Matt Mondoux, our senior financial adviser, as well as Robert Steinberg, founder and CEO of Blue Chip Partners. To kick things off, we have Matt, who will be talking about bond market mechanics. Simply put as: why do bond prices move when interest rates move in a certain way? I think this will be a very timely reminder, if not a timely education session, for all of you folks that are on the line. After which, I will be walking through some current market observations and some views on the path forward before finally turning it over to Robert to discuss some action items, most specifically related to capital gains. And with that, Matt, I'll turn it over to you to start discussing some fixed income market mechanics.
Matthew Mondoux 02:07
Awesome, Daniel, thank you. So you know, I want to start off with a couple of visuals here; I think a picture's worth 1,000 words. And in the most basic sense, bond prices and interest rates have this teeter totter-like relationship, meaning when rates go down, prices often go up. And the opposite is true, when rates go up, prices often go down. We'll get into some examples of why that's the case, but generally speaking, if you think of a teeter totter, when you think of rates and prices, that's going to get you most of the way there with understanding how bonds move relative to interest rates. In the next visual, we're going to get into some definitions. At the end of the day, the bond is an investor, or lender, giving a borrower money, that borrower paying a series of interest payments along the way, and then at the end of a stated term, the principle is returned to the investor so they're made whole. For that borrowing, the borrower got to invest in a business and do something that they needed to do with that money.
A couple of quick definitions; at the end of the day, bonds are debt instruments. Instead of going to a bank or institution, a company can go to the investing public issue bonds and pay interest and raise capital that way. Some key terms: the principal is the amount per bond that the company is borrowing, which shall be borrowed and then returned at maturity. Maturity is the term, or length, of the holding period or that bond's life. The coupon is the amount of interest that the borrower is going to pay the lender, usually on a semi-annual basis. Two key risks: interest rate risks, the risk that rates are going to meaningfully be different than expected by the holder or the investor of the bond, and credit default risk which tend to arise as we're heading into a recession. That's really the risk that a company may go bankrupt or in something less than that full principal amount will be returned to maturity.
So diving into a quick example here: two bonds issued by a hypothetical company, XYZ Corp issues bonds on January 1st to 22nd, it's a ten-year term. The prevailing interest rates at the time of the new issue are 5%. The principal value is at $10,000 per bond, so the coupon payment will be $500 annually. Over the next six months, our rates increase. So XYZ Corp needs to borrow more money or raise more capital. On July 1st, the same bond term (ten years), but interest rates are now 6%. The principal value is the same at $10,000, but that coupon payment is now $600 annually. So what happens now? Bond A and bond B are issued by the same company, but rates have gone up from 5% to 6%. Bond A is now inferior to bond B. Why would you ever get 5%, or $500 annually, when the market now says you should be getting 6%, or $600 in annual coupons? In order for an investor to be indifferent between the two bonds, bond A would need to come down in price. Instead of buying the bond for $10,000, an investor would be willing to pay some lesser amount for a bond A. How do we calculate that? It's a present value calculation that's fairly straightforward with the input. We know the future value at maturity will be $10,000. The coupon payments for bond A are $500 per year. There are nine and a half years left because six months have passed. The current interest rate environment is now 6%, up from 5% when that bond was issued. Let's calculate for the present value, this can be done on Excel. The present value is now $9,291, which is a 7% decline in price. That's the price that a bond investor would be indifferent between buying bond B or bond A, and still having held to maturity, the investor will get $500 and coupon payments annually with $10,000 returned at the end of that term. I hope that was a good example to kind of lay the framework for what we're going to talk about what's happened in the bond market relative to interest rate and prices so far in 2022.
Daniel Dusina 06:59
Great! Thanks, Matt. I think it really is a perfect segue. When we look at what's gone on in financial markets this year, everyone's been well aware of what's going on in the equity market. In periods of steeper declines, generally speaking, investors would expect the fixed income portion of their portfolio to be a bit more of a ballast. That certainly has not been the case this year. I'll explain a little bit as to why and what we are seeing right now in terms of the path forward. So really, what's gone on in the bond market this year has been predominantly driven by inflation. We've all been hearing and experiencing inflation significantly over the last year, coming out of the COVID pandemic that started in 2020. Really, it was an excess of monetary stimulus, a huge amount of pent up demand, a massive push for hiring, and great wage growth, which ultimately led to inflation, or as measured by the Consumer Price Index (CPI), reaching levels of 9%. You'll see that in the blue line on the chart on the left hand side of the screen here. This significant inflation alone hasn't caused bonds to decline in value; it's the reaction to that inflation that has been troublesome for bonds. The Federal Reserve, the central bank in the United States, has a dual mandate. The first is to maintain a full level of employment, and the second is to manage inflation. While they can't directly move the needle on inflation, what they can do is constrain the money supply and tighten financial conditions (AKA increase borrowing costs), and tighten financial conditions overall. What you'll see is that the Federal Reserve was quite slow to react to rising levels of inflation. In more recent months, over the last six months+, they have been incredibly aggressive with raising interest rates. As Matt alluded to earlier, rising interest rates have a directly negative impact on fixed income instruments.
What you'll see on the chart on the right hand side of the screen is that, broadly speaking, just looking at a few specific fixed income indexes that span short through intermediate through long term, the returns have been negative. And it's important to note that the bar you see here in gray represents the longer-term bonds. As interest rates move, longer-term bonds are more exposed. That's certainly been the case this year as long-term bonds have lost more value than intermediate-term bonds. Because we have been dealing with this inflationary pressure and this rapidly rising interest rate environment from the Federal Reserve, this calls to mind something that is known in financial services as one of the behavioral biases. Most specifically, this is something that we would see popping up called "recency bias." Recency bias refers to an investor thinking that what's happening today is going to continue for the indefinite future. Those current dynamics that are being experienced today (AKA very high levels of inflation, rapidly rising interest rates from an overly hawkish Fed), the expectation, the gut reaction, is this is going to happen forever. Financial markets are taking a turn for the worse. I'm here to remind you that many people have been saying these types of things in the past and troublesome market environments. Simply put, these current dynamics will not last forever, and we're already seeing indications that this is the case.
When you look at the chart on the left, one thing that I would say we watch fairly closely here at Blue Chip Partners, is a breakeven inflation rate. This is showing you (in the chart on the left, the brown line) what market participants in fixed-income are expecting the inflation rate to be, on average, over a stated period, in this case, two years. And so while we did start to peak out back in March, and again over in June, we've come down significantly since then, to the point where the market is now expecting and pricing in an average level of inflation that is much more palatable, much more close to the long term target of 2% to 2.5%. What you will find is that as these inflation expectations come down, this is ultimately what drives the yield on fixed income instruments. You can see the correlation between the drop and inflation expectations and the brown line, and the drop in the 10 Year Treasury yield, which is a broadly stated benchmark fixed-income yield instrument. It's important to note that just because the Federal Reserve will continue raising rates through the end of this year and into next year, at least that's what is anticipated at this point, the fixed-income market is forward-looking. Just because interest rates will continue to rise doesn't mean that bond prices are going to just reflect what's happening today. Bond prices will reflect what's happening tomorrow. Given that we have an estimate for the federal funds rate that will be coming down through the back half of next year, the market is starting to price that in, and that's indicated by declining yields. You can look back through periods of history in which you saw the yields on something like a 10 Year Treasury precede actual Federal Reserve interest rate movements. So I think this is fairly key to note right now because the bond market is telling us that these current inflation dynamics will not last forever. While bond returns are still negative for this year, it's fair to note that over the last two months, they regained a fair amount of ground. And certainly, the environment, as we look over the next 12 months, is not necessarily as challenging for fixed-income instruments as it was over the last 12. With all that said, I'm going to turn it over to Robert to talk through some action items that we see in play today.
Robert Steinberg 13:19
Thanks, Daniel. I'm going to touch a little bit more on how bonds have done, and then focus on the tax harvesting type of approach where we can basically take advantage of the losses that we've incurred. This is a chart that really helps understand what the market has been like this year; this chart shows the worst 20 quarters of the S&P 500 since 1990. You can see they're in order of worst return to the 20th worst return. Also on the chart, you see in the orange portion, how bonds perform during that period. In many cases, bond investments actually did well, during periods of low stock market returns. If you look at the chart closely, and again, don't try to get too much into the details, I just want to highlight a couple of things on the chart. The second orange bar from the right shows pretty significant negative bond returns; that was quarter one of this year. The stock market was down, but the bond market action was down even more than the stock market. If you look over on the left-hand side, the fourth column in, you can see, again, negative bond market returns; that was the second quarter of this year. Since 1990, bonds have performed worse this year and in bad stock markets. That explains a lot of how we're feeling. In fact, the second quarter of 2022 was the only time when the stock market was down over 10% and the bond market was negative. Really what we wanted to focus on, as we paired these negative bond returns, was how can we take advantage of them. If you own a bond mutual fund or a bond ETF, it is highly likely that the total amount of your investment, counting the original investment plus any reinvested dividends, is worth less than the value of your bond today. It's just the way the bonds work, especially after you've had a quick spike in interest rates. If you own bonds in a retirement account (401K, IRA), there's nothing that tax loss harvesting can do to help you. But if you own bonds in a non-qualified account (an individual account, a trust account, a joint account), it is going to provide some valuable advice that should save you money on taxes.
The “Cliff Notes” version is to look at your statement, find your bond mutual fund investments, and determine which ones are at a tax loss. As I say, I think almost all of them likely will be. Sell those investments; in other words, take the loss, or as they say in the industry, recognize your loss and then reinvest the proceeds into other bonds that are similar investment objectives. To put it simply, if you had a municipal bond fund that's at a tax loss, sell one municipal bond fund and buy another municipal bond fund. Assuming the same credit rating, the same interest rate, and the same maturity, most people wouldn't care whether they owned a bond issued by the University of Michigan or Michigan State University... a few might. Anyway, if you own one, and it's at a tax loss, we'd recommend swapping it into another bond. If you owned all individual bonds, it might be some work to take tax losses. But thankfully, what ends up happening is most investors own their bond investments through mutual funds or bond ETFs. In that case, in their non-qualified accounts, they may have anywhere from three to five different bond investments that can easily be swapped into additional similar bond investments, and then the tax loss can be taken. And again, this does not help for your retirement accounts, but it does help for non-qualified investments. No one likes to lose money, but taking a tax loss does feel a little bit better when you're offsetting a gain that's already been recognized.
Recently, I was on an airplane; I was sitting in my seat and a gentleman came on the plane after I'd already been seated. He had had a couple of cocktails, I could tell, and he ended up sitting next to me. Before you know it, we're talking about what I did, and he told me that he was having a great year; he was making, between him and his wife, over $500,000 this year. I said, "Well, congratulations. You're in the 35% tax bracket." He goes, "Well, I guess you would know." And then he proceeded to go out and tell me about this great investment that he had made. He said he had bought an oil investment, oil stock, for $10,000 and sold it for $50,000. He said he made a $40,000 capital gain. He was really proud of himself. He goes, "I don't know hardly anybody that's made this type of gain this year. I'm going to take my $40,000 profit and go and use it toward the purchase of a boat." I said, "You know, you're absolutely right that very few investors have made money this year, but you probably don't want to spend $40,000; you'd want to spend $26,000 because you're in the 35% tax bracket and you've recognized a $40,000 gains, so you're going to owe $14,000 in taxes." He wasn't really enthused about that! Then I asked him, "Do you own any other investments?" He said, "Well, no." Then he realized and goes, "Yes, I do own an old bond index ETF mutual fund that I had inherited from my father." He continues, "Something doesn't make sense about it because when I look at the statement it says that I have a $45,000 tax loss, but I know it's worth a lot more than it was when my dad died. I just never followed up on it." I said, "Well, let me explain it to you." I said, "You pay income tax on those dividends each year?" He says, "Well, yeah. That's why my accountant says I don't get a tax refund." I said, "Well, what's ended up happening is based on the value of the investment when your dad died, plus all the reinvested dividends, your investment is actually He was surprised to hear that. I told him, "What you need to do is sell that investment and take the tax loss. If you really want to stay in balance, reinvest that in a similar type of bad investment." He said, "Well, dad always liked bond index mutual funds." I said, "Well, let me explain it to you further. You've recognized a $40,000 gain; if you sell the investment of the bond mutual fund, you will recognize a $45,000 loss. So that's a $5,000 loss. Instead of owning those $14,000 and only being able to put $26,000 towards your boat, you'll actually be able to put the full $40,000. It gets a little bit better than that because you still have $5,000 of loss remaining. What you can do under the current tax law code is you can take $3,000 of those losses and apply those against other income. In your case, with a 35% tax bracket, you will then save another $1,000-$1,050 in income taxes and still have $2,000 to carry forward." I said, "So under this case, you'll end up with $15,050 more than you would have had by not selling investment B." He said, "My dad probably wouldn't be okay with that other bond index fund that you're talking about." So I asked him, "Are you sure that you do not have any other investments?" He then hesitated and said, "Well, in that same statement, it looks like there might be another bond investment that has a $35,000 loss." I said, "Well, you want to take the same approach with that one; sell that one and recognize the $35,000 loss." He goes, "Wait, I've already used up more losses than I can use because I already have $2,000 going to next year." I explained that capital losses never expire and they stay with you until you die. In this case, you'd have $37,000 capital loss carrying forward and at the minimum, you could take $3,000 off your taxes each year and save $1,000 for 12 years. If somehow in the future you had another capital gain, then you can use more of that gain to offset your losses at that point. I said that there's really not a downside to recognizing capital losses, even if you're not able to use them in the current year.
I would have expected that he would at least offer to buy a drink... he didn't. But it was an interesting conversation nevertheless. I want to thank everybody for listening in on the webinar and I'm going to send it back to Daniel for any questions we might have.
Daniel Dusina 22:36
Thanks, Robert. I didn't see any questions come in so I guess I'll just pose one myself to you, Robert. This tax loss harvesting conversation is one we have at Blue Chip Partners all the time. Right now, just given the environment, iIs this something that a lot of people utilize right now? Or is it kind of commonplace? Or is this something that isn't really seen that often?
Robert Steinberg 23:03
I would say, typically, we'll see where advisors are focusing near the end of the year in order to take tax losses. What we've done, much more proactively, is throughout the year, especially with bond investments, we take the losses as we go. The big thing is if, for instance, the stock market has recovered this year, significantly, if the bond market would follow a similar path, then losses that would be available to us will go away. We really do not care whether we own bond A municipal bond fund, or bond B municipal bond funds. What we really want to do is take those tax losses so that we can use them against other gains or other income in the future.
Daniel Dusina 23:55
Great! Thanks, Robert. That's been a very big priority for us here, to strike while the iron is hot. No one likes to recognize a loss, but when you can make it work in your favor it is absolutely something that should be considered. I'll echo Robert's sentiment, and on behalf of Robert, Matt, myself, and the rest of Blue Chip Partners, thanks so much for joining. Hope you guys found this informative and insightful. Stay on the lookout; we'll be doing this again on a monthly basis. Looking forward to providing you guys with some more insights into financial planning and investment management in the future.