It’s no secret that the COVID-19 pandemic has turned on the tap for stock market volatility, but what might be surprising for many investors is how it’s impacted their bond portfolios.
During the first quarter of this year, 30-year Treasuries soared more than 25% as investors around the world sought the relative safety of bonds backed by the U.S. government. Meanwhile, even some of the most credit-worthy corporate bonds endured losses, and some of the riskiest segments of the bond market, namely high-yield bonds, saw double-digit declines.
The bond market has since moved a little closer to something resembling normal, but investors should brace for continued volatility—even in bonds. Losses of any kind can be stressful, but it’s important to keep sight of the critical roles bonds play in an overall portfolio: in addition to providing steady income (albeit quite a bit less when rates are this low) many, but not all, categories of bonds help soften the blow of stock market losses.
Here’s how Covid-19 has impacted bonds.
Government Bonds: The Long and Short of It
U.S. government bonds tend to be the wallflowers of the market, but the sudden shocks beginning in late February coupled with lower interest rates created a rally in government bonds.
Prices, remember, move in the opposite direction as yields. When rates rise, new bonds are issued with higher interest payments, making existing bonds less attractive; their prices go down. The opposite happens when rates decline. The higher yields on existing bonds makes them more attractive, so prices go up.
Bonds with shorter durations, or time to maturity, are less vulnerable to interest rate ups and downs, making short-term government bonds one of the safer options in any environment. During the market selloff in the first quarter, short-term government bond funds gained more than 2%, on average, according to Morningstar Direct. Intermediate-term government bond funds—which own bonds with an average duration between two and 10 years—returned more than 4% during that time.
The most profound swings happened with long-term bonds—particularly those slated to mature decades from now. During the first quarter, funds that own these bonds returned more than 20% on average. Investors shouldn’t expect those kinds of returns going forward. In fact, these long U.S. Treasuries have seen wild swings up—and down—as investors have vacillated between seeking safety and seeking bargains in the stock market.
U.S. Corporate Bonds: Where Credit is Due
As the Covid-19 crisis put the brakes on the economy, the same panic that sent stock prices plunging sent investors fleeing corporate bonds across the board. High-quality corporate bond funds—which carry BBB credit ratings or better—fell nearly 13% during the height of the selloff, ending the first quarter down 3%.
Looking at it another way, the “spread” between corporate bonds and Treasuries with the same maturity reached its widest point in more than 20 years, according to Morningstar.
The worry for investors in corporate bonds is that an economic downturn will lead to bond defaults—corporate borrowers not paying their loans. While this is a real risk, especially for high-yield bonds (bonds rated below BBB and otherwise known as “junk”), this was a classic case of the market throwing out the baby with the bathwater.
Rationality returned as bond fund managers and institutional investors saw that the pendulum had swung too far. Investment-grade corporate bonds went on to recover and were recently up more than 1% for the current year through April 28. The highest-quality (AA) corporates were recently up more than 4%. The riskiest corporates, however, are still trading in the red.
Mortgage-Backed and Municipal Bonds
Mortgage-backed securities and municipal bonds are also key components of most bond portfolios—and their performance has taken widely different paths over the last couple of months.
As the name suggests, mortgage-back securities are made up of mortgages that get bundled together (securitized) and parsed out to investors in the form of mortgage-backed securities, or MBS. This market is composed primarily of agency MBS, which own mortgages backed by Fannie Mae, Freddie Mac and Ginnie Mae. This group has held up surprisingly well throughout this crisis and was recently up more than 3% for the year through April 28.
Municipal bonds—namely, debt issued by state and local governments—have not fared so well in recent months, and understandably. The Covid-19 pandemic has hit many states and cities with the double whammy of increased spending needs and decreased tax revenue. Tax-exempt municipal bonds have declined more than 1.5% nationally, with hard-hit states, such as New York, experiencing the biggest declines.
This does not mean investors should abandon their municipal bonds or any of their bond holdings or mutual funds. History has shown that investors tend to do best if they ride out the waves, and not be tempted to jump ship—assuming it was the right one in the first place.