Could we learn to love the most hated investment in the world?​

With inflation at levels last seen in the 1970s and the Federal Reserve beginning one of its most aggressive rate-hiking cycles, it's no surprise that bond investing is currently the most hated asset in the world. But when we see that everyone is showing bearish sentiment on a particular asset, we are probably looking at an interesting contrarian investment. And indeed it is.

Why has investment in bonds fallen?

Inflation has not been this high since the 1970s, and it forced the Federal Reserve (Fed) to raise interest rates much faster than investors anticipated. Both rising interest rates and high inflation are bad for bonds as an investment asset: high inflation reduces the purchasing power of bond cash flows, while higher rates force existing bonds to trade for less than the new higher-yielding bonds. That's bad for all bonds, but particularly longer-term U.S. Treasuries, which are more sensitive to changes in interest rates and inflation than shorter-term ones.

Why shouldn't we listen to the naysayers?

When everyone is feeling bearish about some investment, and when that “something” has already lost a record amount of money, we have to ask ourselves if they are right to be so negative. Because, somewhat counterintuitively, assets are actually less risky when they experience their biggest losses than when they have been rising steadily for years. And just as buying stocks was a better idea in 2009 than in 2008, buying bonds is arguably a better idea today than it was a year or two ago, when interest rates were still low and falling. There is still a good chance that interest rates and even inflation will rise. And if that happens, of course, we are unlikely to make any money buying bonds, even at these levels. But successful investing has as much to do with asymmetries in risk and reward as it does with how often you are right. And at current levels, the risk-reward of adding bonds to our portfolio looks quite attractive.

Why does risk-reward look so tasty?襤

Higher profitability will increase bond investment

Well yes, the main reason why bonds are collapsing, the rise in interest rates, is the same reason why we might want to make an investment in them. While rising rates will result in large losses for investors in existing bonds, it will offer investors in new bonds a higher return. From that perspective, the higher the interest rates, the better. With these higher rates, demand for bonds should grow again. After all, when we can generate 3% with virtually no risk by making an investment in U.S. Treasuries, investors will be much less incentivized to invest in risky assets like stocks, especially if the outlook for the economy looks challenging.

The bond market is ripe for positive surprises

Bond prices already reflect the more challenging outlook for higher interest rates and inflation. That's clear from the record losses in bond prices. And now that prices are so low, any positive surprise regarding interest rates or inflation could cause bond prices to rebound sharply. In fact, that's what happened in 2019, when the Fed backtracked on its rate hikes after it became clear that the economy couldn't handle higher rates. On the other hand, it would take very bad news for prices to fall even further, given how unpopular the asset already is.

The risk of recession will soon exceed the risk of inflation

The market's main focus right now is inflation, and the Fed's number one priority is fixing it. That's obviously not good for bonds. But the Fed actively intends to slow growth to reduce inflation. And judging by history, it will go overboard: the Federal Reserve has only managed to achieve a “soft landing,” when it did not push the economy into a recession, on one occasion in history. Fed Chair Jerome Powell certainly doesn't seem overconfident this time around, recently saying that a "soft" landing was more likely. And when the Federal Reserve faces a US economy in recession, it won't have much choice: It will have to cut interest rates once again.

So, how do we take advantage of this investment opportunity?❓

Even if the risk-reward profile doesn't convince us about bonds, we may consider adding them to our portfolio for their diversification benefits. While real estate, commodities and stocks would show diversification benefits when the economy is doing well, they are all likely to fall if it falls and sentiment changes. In that environment, only safe-haven assets like gold and US Treasuries are likely to offset their losses. But bonds should benefit more than gold if inflation falls along with economic growth. We would argue that this makes US Treasuries the best hedge at these levels. Both the iShares 7-10 Year Treasury Bond ETF (IEF) is a good solid investment if we are looking to buy bonds. This fund is sensitive to economic growth and inflation, which should give us more bang for our buck in this environment. And let's remember that we don't need to buy everything at once: we can gradually enter over time, as prices fall, a great way to soften our entry point.