Understanding the Performance of Intermediate-term Bonds and Medium-risk Investments in Economic Cycles

Understanding how varying economic cycles influence the performance of intermediate-term bonds and medium-risk investments is essential for any investor looking to make informed decisions. This article delves into the nuances of when these investments tend to outperform and underperform, grounded in historical market data and trends.

Performance Trends in Economic Cycles

Intermediate-term bonds, starting to outperform late in the economic cycle, eventually align with all bond performance patterns as the economy heads towards a recession. However, their return profile distinguishes them from other bond types. This pattern is particularly evident during periods of slow and gradual interest rate hikes, such as the ones experienced in the past.

Historical Context: Rate Hike Cycles

To gain insights, we can examine past rate hike cycles:

2015-Present: Rates rising from 0.00% to current levels 2004-2006: Rates rising from 1.25% to 5.25% over 25 months 1999-2000: Rates rising from 5.0% to 6.5% over 12 months 1994-1995: Rates rising from 3.25% to 6.0% over 13 months

Notably, in the 1999-2000 cycle, intermediate bonds outperformed long-term bonds, and in the 1994-1995 cycle, they nearly matched. In both instances, initial returns were hindered early in the rate hike cycles, primarily due to falling bond values in response to rising rates, which were not offset by rising coupon payments. The key takeaway is that it's important to wait for the right moment to invest.

Current Market Implications

The current period of low nominal inflation and low growth (as of 2017) favors long-term bonds. The absence of significant surprises means that long-term bonds have fewer risks associated with unexpected events, leading to better performance. This trend is evident in the flattening yield curve, which continues to benefit long-term bonds.

Factors contributing to the current market's low rates include market skepticism about the Federal Reserve's forecast of significant future growth, which keeps long-term rates at lower levels. Current conditions do not favor intermediate-term bonds because of the gradual and telegraphed rate hikes. However, if there is a sudden inflation scare that dissipates quickly, it could shift market sentiment. In such a scenario, long-term bonds could take a significant hit, prompting a move towards intermediate-term bonds to mitigate the overall impact of increased yields and reduced bond values.

Signaling the Shift

Investors should keep an eye on immediate developments like inflation scares. A sudden inflation scare can hit long-term bonds more severely, prompting a shift to intermediate-term bonds. This shift minimizes the adverse effects of a temporary rise in yields and the decline in bond values during an inflation scare.

The key indicator to monitor is the yield curve. A flattening yield curve, as observed as of 2017, signals continued outperformance of long-term bonds. A further inversion could occur if the Federal Reserve continues to raise rates while markets stick to the practice of keeping long-term rates low.

Investors in intermediate-term bonds should be prepared to seize opportunities in quick and surprising rate hikes. However, these opportunities are currently not apparent, as the rate hikes are gradual and well-telegraphed.