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01.23.24  |  Investment Management

2024 Outlook Theme #2: It Did Not Take Long to See the Duration Benefit of Higher Bond Yields

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We noted in our 9/30/23 Focal Point: Buried Bonds Can Come Back to Life that “despite recent poor performance, there is reason to be optimistic about Fixed Income: risk adjusted potential looks better… the recent period of rising rates has been bad for Fixed Income investors who invested three years ago, but it sets the table for a better environment going forward. Facing continued uncertainty and volatility in the economy, it would be helpful if Buried Bonds Can Come Back to Life, and return to their historic role of providing income, diversification, and risk reduction to investor portfolios.”

The record 7% jump for the Agg, highlighted in the prior section, was not exactly what we had in mind, but it shows how a reasonable yield relative to duration can set the table for better performance from Fixed Income. Duration measures the sensitivity of a bond’s price to changes in interest rates, with the value representing the percent change in a bond’s price for a 1% change in rates. For example, a bond with a duration of five would lose 5% if interest rates rose 1%.

Chart 1

Chart 1 above shows the yield, duration and ratio of duration to yield of the Agg back to 2000. Why would this matter to an investor? If yield is what you can earn in a year, and duration is the sensitivity of price to a 1% change in yield, then duration to yield is the number of years it would take to earn back the loss in value from a 1% increase in rates.

By the end of 2020, Aggressive Fed action to counteract the Covid pandemic, paired with investor fear of a global recession, combined to push the yield on the Agg down to 1%, and the duration/yield ratio jumped from 3 to 7. This meant that by the end of 2020, it would have taken 7 years of that 1% yield to offset the potential loss of just a 1% rise in interest rates. This is, of course, the reading right before the poor bond period of 2021-2023.  A historically high duration/yield clearly preceded the historically poor 3 year period of returns.

Moving to the end of Q3’23, the yield had jumped to 5% and the duration is down to about 6.5, putting the duration/yield ratio at 1.2, and the best level since before 2010. This set the stage for Q4’s bond market rally. Even today, at the end of Q4’23, and with the Agg yield down to 4.5% from 5.4%, the 1.5 duration/yield ratio suggests bonds are reasonably priced, and at least have the potential to offer some portfolio diversification.

However, it’s not perfect: strong economic growth or stubborn inflation could push rates higher with, for example, the 10yr Treasury heading back towards 5% from 3.88%. A similar 1% move in the Agg’s yield would, based on its duration of 6.5, suggest there is price downside risk of about 6%. But the 4.5% yield would allow income to balance that and minimize losses to about breakeven (over a year, to collect that yield) in such a scenario. Should economic growth come up short, rates would decline, and investors would receive some price appreciation to go along with the yield.

It Did Not Take Long to See the Duration Benefit of Higher Bond Yields. Due to Q4’23’s major move in the bond market, Fixed Income’s outlook is not ideal for all scenarios. But it does still offer decent diversification potential to a portfolio.

Important Disclosures:

Please remember that past performance is no guarantee of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Grimes & Company, Inc. [“Grimes]), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from Grimes. No amount of prior experience or success should not be construed that a certain level of results or satisfaction if Grimes is engaged, or continues to be engaged, to provide investment advisory services. Grimes is neither a law firm, nor a certified public accounting firm, and no portion of the commentary content should be construed as legal or accounting advice. A copy of the Grimes’ current written disclosure Brochure discussing our advisory services and fees continues to remain available upon request or at www.grimesco.comPlease Remember: If you are a Grimes client, please contact Grimes, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services.  Unless, and until, you notify us, in writing, to the contrary, we shall continue to provide services as we do currently. Please Also Remember to advise us if you have not been receiving account statements (at least quarterly) from the account custodian. Historical performance results for investment indices, benchmarks, and/or categories have been provided for general informational/comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results.  It should not be assumed that your Grimes account holdings correspond directly to any comparative indices or categories. Please Also Note: (1) performance results do not reflect the impact of taxes; (2) comparative benchmarks/indices may be more or less volatile than your Grimes accounts; and, (3) a description of each comparative benchmark/index is available upon request.

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