How Economic Trends Affect Bonds

Year to date, the lowest rated corporate bonds and loans have rallied the most amongst all corporate debt types, as economic data has sustainably outperformed asset market expectations. This has set up an interesting situation where as the economy continues to get later into its typical cycle, the riskiest debt (which should, in theory, get hurt the most from a recession) has now nearly completely priced out that potential outcome. Should a recession ultimately manifest, which historical data strongly implies it will (all cycles must end in a recession), high yield bonds and leveraged loans appear quite vulnerable to a meaningful downturn. For some, this could cause a meaningful overconcentration of risk, especially for portfolios that are equity risk dominant.

Financial advisors often tell you “not to worry”—about the scary headline or the crisis of the day. So there’s never anything to worry about? Not quite… There are two long-term risks investors face that should be well understood and addressed. What are they? RISK #1 — Higher inflation. When the cost of things you buy goes up faster than expected, you need a lot more $ to afford them. If your portfolio or its holdings don’t earn higher returns to account for higher inflation, you’re goosed. You might feel safe with a 5% yielding bond in normal times, but if inflation rises to 4-5%, after taxes you’re going to lose a lot of real value by owning it. The 1966-1981 period is the best example of higher inflation & it’s devastating impacts. While the Consumer Price Index increased at a rate of 7%/yr, the S&P 500 Index returned just 6% annually & 5-Yr Treasury Notes only earned 5.8%—16yrs of negative real returns. Long-term bonds got crushed, earning only 2.5% (cumulative return of -49.6% after inflation) RISK #2 — Higher stock and/or bond valuations. Of the two, I’d say this is the lesser risk. But not to be ignored. When stock prices reached record-high levels in the late 1990s, broad stock market indexes eventually declined 50% from 2000-2002. This doesn’t mean that one always predicts the other, certainly not right away—Fed Chairman Alan Greenspan famously fretted about “Irrational Exuberance” in 1996; despite the significant decline in the early 2000s, stock prices never returned to 1996 levels. When we think of high prices vs valuations, we normally think of stocks. Bonds can have high prices too, translating to low yields. For the entirety of the 2010s, bonds yielded 1-3%, far below their long-run average of 5%. As interest rates have ticked up slightly in recent years, long-term bond prices have dropped almost 40%, or once again -50% after inflation (8/2020 to 4/2025) High valuations can have the same devastating effects on stocks & bonds. What should you do about these seemingly disparate risks? Here’s some good news: The solutions are mostly the same. A) to fend off higher inflation, favor more stocks & less bonds AND own higher expected returning stocks—large & small value companies. From 1966-1981, the Dimensional US Large & Small Value Indexes earned +10.4% & +15%/yr gains (3.4% & 8% after inflation). When inflation heats up, value stocks tend to as well. B) to reduce your exposure to high-priced assets…own lower-priced assets, i.e. value stocks (duh!)! From 2000-2006, post 1990s tech boom, the S&P 500 earned just 1.1%/yr. The Dimensional US Large & Small Value Indexes? +12% & +21.2%/yr! Cockroaches have survived for 100 million, increasingly complex years, with one simple defense: when sensing a rush of air, run in the opposite direction. Similarly, complex investing problems don’t require complicated solutions. An equity-oriented, small/value tilted portfolio is the best way to address the most significant risks we face.

US corporate spreads have largely recouped their widening that resulted from the volatility spike we saw back on August 5th. Using the Bloomberg US Corporate Bond Index and the Bloomberg US Corporate High Yield Bond Index as proxies for US investment grade and high yield spreads respectively, we are now back in line with the previous 12-months’ average, implying a sanguine outlook for the US economy in the coming quarters. We point this out because it highlights a key difference for those looking for a sizeable downturn in risk assets over the coming quarters. We are certainly expecting economic growth to slow in the next several months. But we caution not to confuse a soft patch with the onset of a recession. The key here is the catalyst for the growth slowdown. With the labor market cooling, we should expect to see income growth ease. But an income led growth slowdown has very different characteristics than a balance sheet recession. Balance sheet recessions tend to occur when high levels of private debt force individuals or corporates to collectively focus on paying down/paying off/restructuring debt rather than spending or investing. This often results in impaired assets, an increase in default rates and a de-leveraging of balance sheets. The result? Any economic downturn is magnified which then leads to an outsized drop in asset prices. Today, we see credit spreads doing just fine with banks continuing to perform in lock step with the broader market. The ingredients for a massive swoon in risk assets just aren’t there. Might we see some softness in asset prices as we head towards the elections? Sure. Equity prices do go down in bull markets. But something more sinister than a garden variety correction? The Fed is about to embark on an easing cycle which should help ease financial conditions at the margin. But more importantly, this is an income driven slowdown, not a balance sheet recession. Big difference.    

As recession odds have increased, we are paying close attention to economic data and market-based measures of risk to try and discern the outlook for future economic growth. While many are aware of the moves in the stock market, which gets most of the financial press, we lean heavily on messages from the bond market in our analysis. The absolute level of rates, shape of the yield curve and inflation expectations are all important. But at the top of the list might be credit spreads. Bond investors know their returns are capped by the cumulative total of cash flows as bonds are, primarily, issued and mature at the same price. Hence, changes in the perception of the economy, and with it the repayment ability of bond issuers, can be a vitally important marker for economic growth expectations.