A lot has happened since year-end, just over three months ago. The biggest macro event is Russia’s brutal invasion of Ukraine. The human impact has been devastating and tragic to watch in real time. Our hearts remain with the people of Ukraine and all those affected as we hope and pray for a peaceful resolution to this devastating conflict.
As fiduciaries, as difficult as it is, we must put our emotions aside and try to assess the macro economic situation both home and abroad. It was a rough first quarter across the board – with stocks, bonds, U.S., international and emerging markets all hurt by rising interest rates, inflation and the war in Ukraine. Global stocks (MSCI ACWI Index) fell 5.4% for the quarter. Among major global markets, the S&P 500 was a relative outperformer, dropping 4.6%, compared to a 5.9% loss for developed international markets (MSCI EAFE Index) and a drop of 7.0% for Emerging Market (EM) stocks. The relatively mild declines for the full quarter masked the intra-quarter volatility, where peak-to-trough declines were much larger.
Unusually, the damage was worse in the U.S. core bond market than the U.S. stock market. The benchmark Bloomberg U.S. Aggregate Bond Index (the “Agg”) fell 5.9% for the quarter. This was the second-worst quarter for the Agg since Q1 of 1980, when Paul Volcker’s Fed was in full-bore tightening mode. In the fixed-income markets outside of core bonds, high-yield (lower credit quality) bonds lost 4.5%. As we have often noted to you in our discussions, the two enemies of bonds are inflation and fast rising interest rates. Current inflation numbers are at 40-year highs, and with that, the corresponding signals from the Fed that they will increase rates quite aggressively in the months ahead (after remaining passive for longer than most felt appropriate) have led to one of the most difficult quarters for bonds in decades.
Uncertainty is High and Diversification Is Key
The war in Ukraine has caused massive human suffering. From an economic and investment perspective the war is a “stagflationary” supply-shock: it fuels higher inflation via sharply rising commodity prices (especially oil) while also depressing growth via negative impacts on consumer spending. It is also triggering various government and central bank policy responses, which create additional risks and uncertainties for the economy and markets, given already-high inflation and decelerating growth coming into the year.
The COVID-19 pandemic is another wildcard but here the news has been getting better. Over time, the economic damage and disruption should continue to recede, which would support economic growth and mitigate some of the inflationary pressures coming from supply chain disruption and the subpar recovery in the U.S. labor force participation rate, which has contributed to higher U.S. wage inflation.
As we’ve often said about shocking events—in this case a global pandemic followed by war: no one knows how things will play out, and if they think they know, they’re fooling themselves. As Nobel Prize winner Daniel Kahneman put it: “The correct lesson to learn from surprises is that the world is surprising.” In short, we want to build portfolios that are resilient in the face of surprises rather than ones whose success depends on predicting them.
We are confident that our long-term approach, coupled with access to exceptional managers, will enable us to continue to navigate whatever macro and market environments come our way. We can all hope whatever comes next is not as grim as a pandemic or war. But as investors we need to be prepared for anything, even as we hope for better. As always, we thank you for your trust, and we welcome questions you may have about the investment environment or your portfolio.
Inflation Savings Bonds – “I Bonds”
As economic activity has picked up coming out of the pandemic-related slowdown, inflation has risen to 40-year highs. With inflation top of mind, we have received many questions from clients on how I-Bonds work and so we thought it would be helpful to share this primer.
What Are I Bonds?
I Bonds are bonds issued and guaranteed by the U.S. Treasury. I Bond interest is calculated using composite rates based on a fixed interest rate and an inflation-adjusted rate. They earn interest monthly and that interest is added to the value of the bond twice per year. Thus, the principal amount one earns interest on actually increases every six months.
In addition, they are exempt from state and local income taxes and have a maturity of 30 years. However, the bonds can be cashed in 1 year after purchase. I Bonds are also Federal tax-free if they are used to pay for qualified higher education expenses.
The Pro’s for I Bonds
I-Bonds can be attractive for several reasons. First, because rising rates are commonly driven by rising inflation, I Bonds can possibly perform better than nominal Treasury bonds in a rising-rate environment. In fact, the interest rate on I Bonds given the current inflationary environment is expected to be in the 9%-10% range by next month!
Second, because I Bonds usually have low correlations to nominal bonds and other investments, they also bring a diversification benefit that can help smooth overall returns. This is amplified somewhat in that an effect of the “inflated” principal value of I Bonds not being paid until maturity (or cash out) is that it makes them more sensitive to changes in real rates than nominal bonds of comparable maturity.
Third, I Bonds are backed by the full faith and credit of the U.S. government, so credit risk is not a concern.
The Con’s for I Bonds
While a 10%, credit risk-free interest rate can seem appealing; there are some significant drawbacks of I Bonds. First, only $10,000 of I Bonds can be purchased directly from the Treasury via TreasuryDirect.com per person and an additional $5,000 of paper I Bonds with your income tax return. So in total, you can only purchase up to $15,000 of them per person per year.
Next, I Bonds must be held for a minimum of 1 year before they can be cashed out. In addition, if you cash out an I Bond before holding for 5 years, the prior 3 months of interest is forfeited.
Finally, while I Bonds earn interest monthly, the owner does not receive that interest as income until the bond is cashed out given the interest is added to the principal.
The Bottom Line
While the interest rates on I Bonds can be eye-popping, especially when a traditional savings account is yielding close to 0%, all aspects of owning these bonds should be considered. Given the low amount that can be purchased per year and their long holding period, I Bonds are certainly no silver bullet but simply another tool that can be added to portfolios if appropriate.