Book: Principles of Managerial Finance

Chapter 6 - Interest Rates and Bond Valuation

Chapter 7 - Stock Valuation

Question

Based on "The Classic 60-40 Investment Strategy Falls Apart. 'There's No Place to Hide.'" and "Corporate Bonds Bounce Back After Horrible 2022," both located below:

What are the risks of investing in bonds? How can each type of risk be measured and managed?

The Classic 60-40 Investment Strategy Falls Apart. Theres No Place to Hide.

For decades, Americans planning for retirement have been advised to invest in a mixture of stocks and bonds.

The idea was simple. When stocks did well, their portfolios did, too. And when stocks had a bad year, bonds usually did better, which helped offset those losses.

It was one of the most basic, dependable ways of investing, used by millions of Americans. This year it stopped working.

Despite a powerful rally last week after cooler-than-expected inflation data, the S&P 500 is down in 2022 about 15%, including dividends, while bonds are in their first bear market in decades. A portfolio with 60% of its money invested in U.S. stocks and 40% invested in the 10-year U.S. Treasury note has lost 15% this year. That puts the 60-40 investment mix on track for its worst year since 1937, according to an analysis by investment research and asset management firm Leuthold Group.

Many Americans are seeing decades worth of savings shrink, week by week. Belt-tightening among millions of households could serve as yet another drag on an economy already suffering from high inflation, a slowing housing market and rapidly rising interest rates.

Eileen Pollock, a 70-year-old retiree living in Baltimore, has seen the value of her portfolio, with a roughly 60-40 mix, dip by hundreds of thousands of dollars. The former legal secretary had amassed more than a million dollars in her retirement accounts. To build her savings, she left New York to live in a less expensive city and skipped vacations for many years.

A million dollars seems like a great deal of money, but I realized its not, she said. I saw my money was piece by large piece disappearing.

Bonds have helped offset the pain of the previous market crises, including the bursting of the dot-com bubble in 2000, the global financial crisis of 2008, and, most recently, the brief but punishing bear market brought about by the Covid-19 pandemic in 2020.

This year, U.S. Treasurys are having what could wind up being their worst year going back to 1801, according to Leuthold, as central banks have swiftly raised interest rates in a bid to quell inflation. The iShares Core U.S. Aggregate Bond exchange-traded fund, which tracks investment-grade bonds, has lost 14% on a total return basis.

The declines weigh especially on baby boomers, who have hit retirement age in worse financial shape than the generation before them and have fewer earning years ahead to recover investment losses.

Whats shocking investors is theres no place to hide, said Peter Mallouk, president and chief executive of wealth-management company Creative Planning in Overland Park, Kan. Everything on the statement is blood red.

In 2008the year the housing market crashed, Lehman Brothers declared bankruptcy and Congress agreed to an unprecedented bailout plan to rescue the financial systembond prices soared. Investors with 60% of their money in stocks and 40% in bonds would have outperformed investors with all of their money in stocks by 23 percentage points, according to Leuthold.

Worst annual returns for a portfolio in 60% stocks and 40% bonds

60/40 stock/bond portfolio return

Stock return

Bond return

TOTAL RETURN

-40%

-20%

0%

20%

27%

1931

20%

1937

So far this year,

bonds haven't

helped a

60/40 portfolio

20%

1907

16%

1917

15%

2022

Bonds lost

slightly

more than

stocks

14%

1974

14%

2008

13%

In 2008, bonds

returned 20%,

offsetting stock

losses

1930

10%

1920

7.8%

1893

Note: Worst 10 years since 1878. Stock return refers to the S&P 500. Bond return refers to 10-year U.S. Treasury note.

Source: Leuthold Group

Aziz Sunderji/THE WALL STREET JOURNAL

Investors with a mix of stocks and bonds also came out significantly ahead of those putting all their money in stocks in 1917, the year the U.S. entered World War I; in 1930, during the Great Depression; and in 1974, after a staggering market selloff brought on by a series of crises including surging oil prices, double-digit inflation and Richard Nixons resignation over the Watergate scandal.

That final year, the S&P 500 declined 26%, including dividends. But 10-year Treasurys returned 4.1%. That meant a portfolio with 60% of its money in stocks and the remainder in bonds would have ended the year down 14%a big hit, but still much better than the 26% loss it would have suffered had it been all in stocks.

Investors in a U.S. government bond are virtually certain to be paid their principal back when the bond matures. But before then, the bonds value can fluctuate wildlyespecially in the case of a bond that has many years before maturity. An investor holding a hypothetical older bond with a $100 face value and 1% coupon, or annual interest rate, that matures in seven years would get far less than $100 if she sold that bond today. Thats because the newest seven-year Treasury was recently issued with a coupon of 4%. To compensate for her bond coming with a much smaller coupon, the investor would have to sell at a lower price.

Miss Pollock said she wishes she didnt have so much money tied up in the markets, but is in too deep to pull out of her investments. She has resigned herself to wait things outhoping that the market will eventually go back up.

If I get out of it, Ill only lock my losses in, she said. Ill just have to hang on to my belief in the American economy.

Delaine Faris, 60, retired from her job as a project manager in 2019. She had hoped her husband, a technology consultant, could join her in a few years, based on how much their savings mix of 70% stocks and 30% bonds had grown over the previous decade. The couple took a big trip to Europe, then Argentina. They sold their house in Atlanta and moved to an exurb where they planned to settle down.

I saved and invested responsibly and made plans, Ms. Faris said.

Earlier this year, she strongly considered returning to work to supplement their savings. Layoffs in the technology industry have added to the couples worries.

She considers herself and her husband fortunate that they still have a home, his job, their health and their savings, but the past year has been a big gut check, she said. Millions of us said, Were going to retire early, yay, and now were thinking, Wait a second, what the heck happened?

Roughly 51% of retirees are living on less than half of their preretirement annual income, according to Goldman Sachs Asset Management, which this summer conducted a survey of retired Americans between the ages of 50 and 75. Nearly half of respondents retired early because of reasons outside their control, including poor health, losing their jobs and needing to take care of family members. Only 7% of survey respondents said they left the workforce because they had managed to save up enough money for retirement.

Most Americans said they would prefer to rely on guaranteed sources of income, like Social Security, to fund their retirementnot returns from volatile markets. But only 55% of retirees are able to do so, the firm found.

Susan Hodges, 66, and her wife decided to pull all their money out of the markets in May. We can only take so much anxiety, she said.

The couple, based in Rio Rancho, N.M., have since put some money back into stocks, but remained cautious, keeping roughly 10% of their overall retirement funds in the market. The couple has also become extra judicious about where and how they spend their money, cutting back on dining out and discussing online purchases with each other before pulling the trigger.

Market returns have grown increasingly important for U.S. households trying to prepare for retirement. In 1983, 88% of workers with an employer-provided retirement plan had coverage that included a defined-benefit pension, which provides payments for life, according to a report from the Center for Retirement Research at Boston College using data from the Federal Reserve.

In the following decades, traditional pensions were replaced by 401(k)-style retirement plans. By 2019, 73% of workers with an employer plan had only defined-contribution coverage, in which the amount of money available in retirement depends on how much workers and employers put into the plan and how that money is invested.

An October survey from the American Association of Individual Investors found that respondents had about 62% of their portfolios in stocks, 14% in bonds and 25% in cash. That stock allocation matched the average in data going back to 1987, while investors were keeping a bit less in bonds and more in cash than the long-term norm.

Defined-contribution retirement plans have leaned into stocks. In the 401(k)s of workers still employed by their retirement plans sponsor, 68% of participants assets were invested in equity securities, including the stock portions of funds, at the end of 2019, while 29% of assets were in fixed-income securities, according to a report earlier this year from the Employee Benefit Research Institute and the Investment Company Institute.

No one knows when the typical stock-and-bond portfolio will start working again, but the economic outlook is darkening. Economists surveyed by The Wall Street Journal expect the U.S. to enter a recession within the next 12 months as slowing growth forces employers to pull back on hiring.

Unlike during the dot-com crash, the financial crisis and the early days of the pandemic, the Fed appears unlikely to swoop to the markets rescue by loosening monetary conditions. Fed Chairman Jerome Powell has emphasized the need to keep raising interest rates to bring down inflation, even if it results in some economic pain.

Many financial advisers caution against abandoning the stock-and-bond approach after just one year of unusually bad returns. They point to charts tracking the S&P 500s upward climb over the decades and note that throughout history, investors who bought at the end of the worst selloffs have been richly rewarded. Someone who entered the U.S. stock market during the depths of the financial crisis in 2009 would have received a return of roughly 361% over the following 11 yearsenjoying stocks longest-ever stretch of gains.

For now, some advisers are reminding clients of the importance of staying diversified, such as by holding commodities like oil and precious metals along with stocks and bonds, or of holding enough cash to cover coming bills.

Eric Walters, a financial adviser based in Greenwood Village, Colo., said his clients have seemed notably sober as of late.

Often we will start meetings and they will nervously ask, Are we OK? he said. I think theyre referring to the country and the economy and the stock market, and theyre also referring to themselves personally: Are we OK financially?

Johnathan Bowden, a 64-year-old in Conroe, Texas, is no stranger to investing. He has read financial news for decades, tunes into webinars hosted by Morgan Stanleys E*Trade platform and trades options on the side.

After retiring in June 2021, he began worrying the stock markets supercharged run wouldnt last. His fears were confirmed this year.

Rather than allowing himself to obsess over how badly the markets were doing, Mr. Bowden returned to his former job as a procurement manager. He works part-timejust enough to give himself a financial cushion, and to occupy himself during the week.

I spent 40 years making this money, Mr. Bowden said. I dont want to blow it.

Corporate Bonds Bounce Back After Horrible 2022

Corporate bonds have leapt out of the starting gate to begin 2023, a salve to investors who suffered double-digit losses last year.

Company bond prices have climbed and their yields have declined, particularly in relation to those on low-risk government notes. That reflects traders improving conviction that businesses will withstand any coming economic downturn with limited stress. The gains have erased a portion of last years miserable results for fixed-income markets, which cracked many long-held Wall Street strategies for ensuring stability in investors portfolios.

Intercontinental Exchanges index of investment-grade corporate bonds has returned 3.1% so far this year, including price changes and interest payments. Junk-rated bonds, which are below investment-grade, have done better, adding 4.4%.

That is a reversal from last year, which mostly saw bond yields rush higher at every turn. Yields rise as bond prices fall.

Twin threats pummeled prices in 2022: rising interest rates, which slashed the value of lower-yielding bonds already in the market, and fears of a recession, which scared off some investors from lending to businesses that might struggle to repay debt. ICEs high-yield and investment-grade indexes lost 11% and 15% last year respectively.

Feb. 2022

'23

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

pct. pts

High-yield

Investment-grade

In recent weeks, however, investors have wagered that both of those challenges are receding. Following last weeks Federal Reserve meeting, bets in futures markets showed that traders grew more convinced the Fed is approaching the end of its series of rate increases. They have even been projectingcontrary to the Feds own forecastthat the central bank will switch to cutting rates before the end of the year.

Fridays rock-solid employment report jostled that outlook, forcing investors to consider whether the Fed may still need to raise rates further to cool the economy. The surprisingly strong data brought a reminder that the economic outlook remains highly uncertain, said Michael Chang, a portfolio manager at Vanguard. Bonds declined in subsequent trading.

The falling unemployment rate, however, also added to evidence that a deep downturn remains far off. This month, the extra yieldor spreadthat investors demand to hold junk bonds instead of U.S. Treasurys has fallen to less than 4 percentage points, well below levels that represent serious concerns about defaults. Junk-bond spreads topped 10 percentage points in the early days of the Covid-19 pandemic, and rose above 20 percentage points during the 2008 financial crisis.

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Stronger corporate balance sheetsas reflected in higher credit ratingsmean that risks are lower in this economic cycle than during past downturns, Mr. Chang said. But it remains too early to sound the all-clear, he added.

Given where spreads are today, they dont leave much scope to absorb many negative surprises, Mr. Chang said. He has been favoring high-yield bonds from industries that are still benefiting from a pandemic recovery, such as airlines and cruise lines, while avoiding sectors such as housing where demand is receding as the pandemic fades and interest rates rise.

Smoothing the outlook for bonds this year is a dearth of coming debt maturities. Investment-grade and junk-rated companies alike rushed to take advantage of cheap borrowing costs during the pandemic, resetting the clock on when they must refinance their debt.

2023

'25

'30

'35

0

25

50

75

100

125

150

175

200

225

250

$275

billion

About $106 billion of high-yield bonds are set to mature this year and next, compared with $881 billion between 2026 and 2029, according to Goldman Sachs research. That suggests a near-term recession wouldnt coincide with large funding needs for risky borrowers, muting the potential for a credit crunch.

Last year, a slowing housing market, declining consumer spending, layoffs at some big tech companies and warning signs in the government-bond market all sparked concerns that a recession could be nearing. But credit risks for even junk-rated companies might be more benign under the surface, the Goldmans researchers found.

Their analysis of borrowers financial statements concluded that the default rate among junk-rated companies may hit 2.8% this year, a rise from recent months but well below the levels reached during past recessions.

This years falling yields have somewhat reduced companies borrowing costs, enticing some corporate finance chiefs to raise funds by selling new bonds despite rates that remain relatively high overall. Junk-rated companies typically sold new debt at yields of 8.5% in January, down from more than 12% last fall, according to Leveraged Commentary & Data.

Low-rated companies issued $20.6 billion of bonds last month, helping to thaw 2022s frozen fundraising market, LCDs data show. The Feds rapid interest-rate increases warded off borrowers last year, capping issuance below $10 billion in every month from May through December.

Borrowing has jumped out to a solid start in February. A $2 billion investment-grade bond sale from Northrop Grumman Corp. NOC -1.03%decrease; red down pointing triangle and a $750 million junk-rated offering from Albertsons ACI -0.38%decrease; red down pointing triangle Cos. contributed to more than $15 billion in new issuance across the two markets on Monday alone.

Healthy volumes of low-rated debt issuance are welcome news to investors looking for deals, because greater supply can push down bond prices and lift yields, said Sean Feeley, a fixed-income portfolio manager at Barings. Mr. Feeley said that at spreads of less than 4 percentage points, junk bonds may not be adequately compensating investors for the risk that corporate earnings could falter later this year.

There has just been a relentless bid for risk so far this year, Mr. Feeley said. Weve been pining for more new issuance to sop up this excess demand.