The textbooks teach that bonds are among the safest places for defensive investing. But that scenario didn’t play out in last year’s market rout. And this year, although stocks have rebounded, bonds have continued trending lower. Safety in the bond market, it seems, has gone missing.
A combination of high inflation, high interest rates and too much accumulated debt is weighing on fixed-income markets.
Consider that the Vanguard Total Bond Market ETF (BND), a core holding in many portfolios, is on the verge of recording three consecutive yearly losses. The $94.8 billion fund is the largest bond ETF by assets. Sixty-seven percent of its portfolio is U.S. government debt, while the remaining portion is spread across corporate and mortgage-backed securities.
Things have been even worse for investors with ETFs linked to longer-dated bonds. Despite amassing a record $18 billion in inflows in 2023, the iShares 20+ Year Treasury Bond ETF (TLT) has fallen 14.82% since the beginning of the year. The fund has seen a 45% crash over the past three years.
Meanwhile, bond bears are printing money.
The Direxion Daily 20+ Year Treasury Bear 3X ETF (TMV) has surged 313% during the past year and just over 60% this year alone. The fund aims for 300% daily opposite exposure to long-term U.S. Treasurys.
Rising interest rates have complicated matters for the U.S. government. The Federal Reserve’s aggressive interest rate hikes since March 2022 are dramatically increasing the government’s interest cost.
Investing luminary Ray Dalio, the billionaire founder of hedge fund Bridgewater Associates, sees big problems ahead in the bond market. In a CNBC appearance last month, he warned of an impending debt crisis.
Political infighting about the U.S. debt limit earlier this year brought the U.S. government to within days of defaulting on its debt. With the politicians seemingly unable to agree on anything, investors like Dalio are worried that another close call on defaulting or an unexpected credit event could shock the bond market.
The bond market faces other problems as well: there’s too much debt, and the costs for servicing it are surging.
Roughly 75% of U.S. Treasurys will have to be refinanced within the next five years. And the days of paying near zero percent rates on debt are long gone, leaving the government with little choice but to pay the piper.
Just adding 1% in interest cost to the Congressional Budget Office’s baseline projections for the rest of this decade (2.2% is the CBO baseline) pushes the government’s annual interest bill to $2 trillion. For context, individual income taxes are expected to bring in just $2.5 trillion this year.
None of this has gone unnoticed by business leaders.
In JPMorgan Chase’s third quarter earnings report, Jamie Dimon, the firm’s CEO, said, “Extremely high government debt levels with the largest peacetime fiscal deficits ever are increasing the risks that inflation remains elevated and that interest rates rise further from here.”
Recent Treasury bond auctions show weakening demand for U.S. debt. This is despite dramatically higher bond yields.
For certain, the U.S. government’s honeymoon period of financing runaway spending with cheap debt is long over. And while advisors and ETF investors absorb what comes next, they’ll have plenty of 2023 tax-loss harvesting opportunities with bonds.
