Major Stock Markets Fall Again as Bonds Take the Spotlight

Wednesday was another day of mixed performance on Wall Street, as major stock market benchmarks were mixed. Investors' preference for growth stocks seemed to reassert itself, as the Nasdaq Composite (^IXIC -1.49%) once again managed to gain substantial ground in setting a new record high and eclipsing the 10,000 milestone. However, market participants were generally more concerned with whether the economy will successfully turn itself around from the coronavirus-inspired shutdowns that brought the business world to a standstill for several months. The Dow Jones Industrial Average (^DJI -0.77%) and S&P 500 (^GSPC -1.11%) both posted losses on the day.

Today's stock market

Data source: Yahoo! Finance.

Bad news for stocks was good news for bonds, as the bond market celebrated the latest comments from the Federal Reserve. With central banks doing what they can to stoke greater economic activity, interest rates look poised to stay low for the foreseeable future.

Image source: Getty Images.

Why bonds?

At first glance, the idea of low interest rates would seem to be a bad thing for bonds. After all, the interest payments that bond investors receive hinge on prevailing rates in the market when those bonds are issued. Low rates on new bonds mean less income for investors.

However, investors who own existing bonds at a fixed interest rate benefit when prevailing rates in the market go down. Lower rates elsewhere make their current bond holdings look more attractive, because the bonds they own were issued at a time when rates were higher. Those looking to buy bonds are willing to pay more for higher-interest bonds, and that pushes their prices higher.

It's those price increases that have delivered huge returns to bond investors over the years, and especially so far in 2020. You can see the impact in broad-based bond funds like Vanguard Total Bond Market (BND -0.21%), which is up 5% this year. But the effect is even more pronounced in the Treasury bond market, and the longer the bond has before maturity, the greater the boost to returns. The iShares 7-10 Year Treasury Bond ETF (NASDAQ: IEF), which roughly tracks the benchmark 10-year Treasury, is up 10% so far in 2020. The longer-term iShares 20+ Year Treasury ETF (TLT -0.82%), on the other hand, is up almost 19%, and the ultra-long maturity PIMCO 25+ Year Zero Coupon ETF (ZROZ -1.41%) has climbed more than 25% this year.

Waiting for the music to stop

With 10-year Treasury yields below 0.75% and 30-year yields just above 1.5%, there's only so much further rates can fall. Yet investors read the Fed's pronouncement today as signaling its intent to keep rates low until 2022 at the earliest. That's a green light for bonds, and many expect the central bank to incorporate long-term bond purchases into its monetary policy in a way that would further depress yields and boost prices.

Even with the Fed's moves, though, bond investors have to be careful. Deficits are soaring, and that's forcing the Treasury to issue more bonds than ever. Demand is still strong, but that could change at a moment's notice -- and when it does, the pain for holders of bond ETFs will be extreme.

The bond market  has been extremely strong as a long-term investment for decades, as double-digit interest rates during the inflationary periods of the late 1970s and early 1980s have given way to current conditions. How long that strength will continue is uncertain, but plenty of investors expect the party to last at least a little longer.