Bonds Could Make a Comeback as a Hedge Against a Recession

The U.S. inflation rate reached a 41-year high of 8.5% in March before slowing to 8.3% in April. While Russia’s invasion of Ukraine sparked higher energy prices, inflation began rising long before the geopolitical crisis. The COVID-19 pandemic led to a sharp increase in relief spending and consumer spending, and supply chain disruptions increased prices.

The geopolitical crisis in Europe exacerbated inflation by pushing energy prices significantly higher over the past few months. In March, crude oil spiked to nearly $130 per barrel and continues to trade in a range of $100 to $110 per barrel. The Russian invasion also sparked an increase in wheat and other commodities, influencing the price of food in supermarkets.

More recently, China’s COVID-19 lockdowns in Shanghai and other populated regions could further disrupt supply chains over the coming months. If that happens, consumers could see even higher inflation until supply chains and commodity markets stabilize, which could hurt consumer spending and economic growth, leading to a recession.

The Federal Reserve’s response to rising inflation has been a swift increase in interest rates. According to FedWatch, the futures market predicts that interest rates will reach a 275 to 300 basis point range by year-end. These rising rates could further slow down the economy, particularly if the central bank is too aggressive.

Rising interest rates hurt existing bondholders because they’re locked into lower rates. For example, a bond that yields 2.5% during an environment with 8% inflation is losing 5.5% in real terms. As a result, bond prices have plummeted in recent months – the iShares Core US Aggregate Bond ETF (AGG) is down nearly 10%, on a total return basis, so far this year.

The good news is that the interest rate on new bond issues is on the rise with 30-year Treasury yields surpassing 3% for the first time since 2019. Moreover, many investors expect a short and sharp tightening cycle that could limit the impact on the bond market after the initial jolt, although inflation will ultimately determine what happens next.

Be sure to check our Portfolio Management Channel to learn more about different portfolio rebalancing strategies.

Investors looking to hedge against inflation with bonds should be selective. After all, soaring inflation and supply chain issues have already significantly increased risk in the $1.5 trillion junk bond space. For instance, Bausch Health – one of the largest junk bond issuers – recently missed earnings estimates and saw a sharp decrease in its bonds’ value.

Rather than buying aggregate bond portfolios, Morgan Stanley recommends that investors should look at investment-grade corporate bonds, select high-yield bonds, securitized credit and emerging market debt as attractive opportunities. Alternatively, they can look toward actively managed, fixed income funds to provide expertise to help navigate the market.

There are several active bond ETFs that could fit the bill:

 

Data as of June 9, 2022

Most investors believe that a recession is imminent over the next couple of years, but there aren’t many good places to park capital with high inflation and rising interest rates. While bonds have suffered in recent months, there are some opportunities in the market that can help investors generate a yield while remaining safe.

Make sure to visit our News section to catch up with the latest news about income investing.