Market report

Focus on bond investments: Why bonds are now becoming interesting again and how you should position yourself.

September 18, 2023
7 min.
Focus on bond investments: Why bonds are now becoming interesting again and how you should position yourself.

Chart of the week

Source: Axa

Many investors invest in stocks. Buying a Nestlé or Apple share is quite easy and many have already done so. With bonds, it is more difficult. Here there are the following investment decisions to make:

- Maturity (duration)

- Credit quality (AAA up to C)

- Credit spreads

- Central bank interest rates

Why this is important
With shares it is comparably simple. You like Nestlé's products and think everyone else does too, you love the iPhone and all your friends have one too, or you see the long queue for the Swatch store and buy the shares.
With bonds, it's more challenging. From Nestlé there are 95 bonds, from Apple 67 bonds and from Swatch there is only one convertible bond, which depending on the course of the share price can ensure that you get the shares delivered.
In the rest of the text, we will go into why bonds are now a good alternative again and how to proceed when buying bonds.
For quick readers, here is the current conclusion:
We invest in government bonds with a maturity of 6 to 12 months. Here, no ETF is worthwhile, you can buy the bond directly.

Bonds - Basics
Let's assume you buy a bond from Nestlé for EUR 5000 with a maturity of one year and an interest rate of 4%.

The day after the purchase, interest rates rise by 1%. What happens to the price of the bond now? A new buyer could buy a bond for 5% interest. To compensate for this, the price of our purchased bond now drops to 4950. However, the price of 4950 is not given now. The price is always given in relation to the nominal value. We have bought at 100% and will get back 100% in one year. In the above example, the price now drops from 100% to 99%.

A buyer who buys today earns the 4% interest plus a capital gain of 1% because he can return the bond in one year for 100%.
Now the same example, but the Nestlé bond has a maturity of 10 years. Again, after the purchase, the interest rate rises from 4% to 5%. Our bond now drops to a value of 90%.
And the last example: We hold a Nestlé bond with 4% and a maturity of 10 years. But now the interest rate drops by 1%. The price of the bond now rises to 110%.

If you buy a bond and interest rates rise, you make a capital loss. If you keep the bond until the end, in our example 10 years, you get back 100% and make no loss. But if you need the money before that, you have to bear bigger losses.
This is exactly what happened to many investors, but also to the US regional banks in the past 2 years. This triggered the banking crisis in the spring and the banks had to be rescued by the state or sold to a competitor.

Bonds, why now?
From 1980 to 2021, we had a period of 40 years with a downward trend in interest rates.

Source: FRED, 18.09.2023

Then the Federal Reserve began to raise interest rates very aggressively:

Source: Isabelnet, 01.12.2022

The chart shows the most important interest rate increase cycles of the U.S. Federal Reserve since 1950. We are currently experiencing the third-fastest increase cycle in almost 100 years. The 1973 cycle is comparable, which is why this period is so often used as a comparison for the current situation.
The rapid increase in interest rates is resulting in the largest losses for bond investors since 1945!

But now there are increasing signs that interest rates will not rise any further. This makes bonds an interesting alternative again.

Source: CME FedWatch Tool, 18.9.2023

The chart shows the expected interest rate decisions of the U.S. Federal Reserve in the next 12 meetings. The blue-marked digits show what the majority of investors expect. They expect interest rates to remain high until May 2024 and then fall again.

The picture is similar in Europe:

Source: YouTube, Mario Lochner. 9.9.2023, Time stamp 6.22

Another interest rate hike is expected here, but then rising interest rates should come to an end in Europe as well.

But that is not all. Interest rates have returned to a level where bonds are becoming a real alternative to equities.
The profit yield of each company can be calculated. This is the return on capital employed. This number can be aggregated from all companies in the S&P 500 stock index. Currently, the earnings yield of the S&P 500 is 3.93%.

Source: Isabelnet, 09.09.2023

The chart above shows the relationship between the earnings yield of the US stock market and short-term government bonds. If the line is above the zero line, it is worth buying stocks, if it is below, bonds are the better choice.

Currently, there is more to be said for investing in bonds than in stocks. To change this, stocks would have to generate a higher earnings yield. Currently, however, that doesn't look so rosy.
A short-term 3-month U.S. Treasury bond currently yields 5.3%. That is 1.27% more than the yield on equities. A rational investor therefore currently prefers bonds to equities in the short term.

Bonds - Inverse Yield Curve Feature
Normally, long-term interest rates are higher than short-term interest rates.

Source: TradingFreaks, 18.9.2023

When you lend money to a debtor, you have to make a forecast whether you will get all your money back at the end of the term. Such a forecast is easier to make over 1 year than over 10 years. The risk that a company will not be able to pay back the bonds is higher in 10 years than in 1 year.
Currently, it is different because many expect a recession. It is easier to forecast how much a company will earn over 10 years than in a recession. An inverted yield curve rarely happens.

Source: YouTube, InvestAnswers, 25.03.2023, Time stamp 24:30

The chart shows the difference between the 10-year and 2-year interest rates for U.S. government bonds (blue line). Normally, long-term interest rates are higher than short-term interest rates. Marked with a black circle are the phases in which this was not the case. That is, the phases in which the yield curve was inverted.
In ALL of these cases since 1985, a recession occurred 6-9 months after the inverse yield curve occurred. Furthermore, the unemployment rate (yellow line) then also rises sharply.
This inverse yield curve for government bonds can be seen in the current values as of 09/18/2023:

                        6 months       1 year      10 years

USA                 5.5%               5.4%        4.4%
Germany          3.8%               3.2%        2.7%
France             3.9%               3.8%        3.2%
Switzerland     1.9%                1.94%      1.1%

We are therefore investing the funds we want to hold in cash in the short term in 6-12 month government bonds from the USA, Germany and France.

In Switzerland, the situation is still somewhat mixed. 1.9% interest over 6 months is still much lower than the foreign exchange yield in Swiss equities. In addition, trading fees eat away part of the interest.

Bonds - debtor and credit quality
When you lend money, i.e. buy bonds, the quality of the debtor is crucial. If the debtor is solid, there is a high probability that you will get your money back.

Because the market is so large and confusing, rating companies have discovered credit rating as a business model. The best known are Moody, S&P and Fitch.

Source: Wikipedia, 18.09.2023

The chart shows the raiting classifications of these companies. These range from AAA to D. AAA or Aaa is the highest rating. If an investor restricts himself only to such bonds, the probability of default on the bond is effectively zero. But the yield is also lower than for a bond rated BBB or lower.

Bonds rated AAA to BBB are also called investment grade. Many investors, such as pension funds, are only allowed to invest in such bonds.

Source: Moodys, Ratinggrundlagen, page 7

The chart shows the default rates of the bonds according to the rating they had. From AAA to BBB, the default rate is very low. But then it starts to rise rapidly. If you want to invest in the non-investment grade segment, i.e. bonds with a rating below BBB, in order to earn more interest, it is worthwhile to do so with an investment fund. This is broadly spread and the manager additionally checks all debtors.
The general principle is that the lower the investment risk, the lower the interest rate; the higher the investment risk, the higher the interest rate.

Quelle: Schroder, Unternehmensanleihen, 19.9.2023

As a rule, government bonds have the lowest risk. But not all of them, of course. Greece has a higher risk than Germany. Therefore, for Europe, government bonds from Germany and for the USD, those from America are usually seen as risk-free bonds. The difference and therefore the higher risk of other bonds is often given as a spread. This spread can fluctuate very strongly in some cases.

Source: Schroder, Neue Spielregeln für Unternehmensanleihen und Aktien in einer Rezession?, 17.07.2023

The chart shows the course of the S&P 500 share price (green) and the spreads of high-yield bonds in the USA (blue) versus government bonds during the recession of 2008, when the financial crisis had triggered a recession. Many companies were struggling and the default rate of debtors was rising sharply.

Currently, many investors believe that we are at the same point as in 2007, i.e. just before a recession. When corporate bond spreads rise, it means that companies have to pay a higher interest rate.

In such a market phase, corporate bond rates continue to rise, but government bond rates do not. Therefore, we currently prefer government bonds and would avoid corporate bonds.
However, this may change. In the chart above, you can see that bond specs peaked in December 2008 and then went back down. And that was before the recession ended and stock prices recovered. Then in the final stages of the recession, when a recovery is in the offing, high-yield bonds are an excellent investment and will have a better return than stocks. But we are not there yet.

Bonds - Influence of Central Bank Interest Rates
We learned above that government bonds from the U.S. or Germany are considered risk-free investments. All other interest rates of more risky investments take the risk-free rates as a basis.
Therefore, for any investment in bonds, it is important to pay attention to the key interest rates of the central banks, because this is the basis for the level of yields on government bonds.
That is why we have warned against buying bonds for 3 years. If clients wanted investments in bonds, we invested in so-called absolute return strategies, which can profit even in an environment of rising interest rates.
As the peak in central bank rates is already here or seems to be close, we are now changing our investment behavior and investing again in government bonds with a maturity of 6-12 months.

Source: Twitter, Lance Roberts, @LanceRoberts, 07.09.2023

The chart shows the key interest rates in the USA (light blue) and the interest rates on the 10-year government bond (dark blue). The key interest rates are currently in a range of 5.25% to 5.5%. The 6-month government bond rates are at the upper band of 5.5%. As shown in the chart, the long-term interest rates are still one percent lower. This is due to the inverse yield curve.

There is a risk that they will rise another percent before they turn downward. We are still very cautious with regard to investments in long-term bonds.

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