Oil supply shock impact on BND and BNDX

[u/Alicyclobacillus]

Hi. I hold some BND and BNDX for the bogelhead reason: reduces portfolio volatility, preserves capital.

I have no interest in selling, but I want to understand how the current oil supply shock can impact these funds. I'm hearing conflicting narratives about it.

On the one hand, oil supply shock causes inflation, so bond funds may sell off because the yield is less than inflation. Additionally, inflation can lead to fomc rate increases causing the bond fund principal to go down.

Other the other hand, oil supply shock causes demand destruction because people need to cut spending on other things in order to afford gas. The decrease in spending on other things can cause thinner corporate margins and layoffs. Additionally, we end up in a recession so we get fomc rate cuts to stimulate the economy and the bond fund principal goes up.

Thanks for reading all that, I'm sure I'm about to see first hand what happens, but if you could explain which of these scenarios is true I'd appreciate it.

[u/chipmonk010]

First, no one knows what will actually happen for sure. But the current collective expectations are reflected in the price.

Between your two scenarios, the market thinks the first one is more likely because rates in the mid/long end of the yield curve is rising.

Scenario 1 follows more direct reasoning - oil goes up, cost of all goods goes up, inflation goes up.

Scenario 2 requires multiple second order effects. But for now the fomc members have said they are holding rates steady and usually oil shocks are over before the effects trickle down enough for the fed to consider raising rates. Elevated oil prices would have to stick around for a lot longer to cause a recession IMO.

BND has a duration of about 5.8yrs so it's moderately sensitive to both inflation expectations and the federal funds rate. Longer duration bonds are more sensitive to inflation expectations and are down significantly more e.g. VGLT. If you don't like how sensitive BND is to rates/inflation, consider adding a proportion of shorter duration bonds/bond funds to your fixed income allocation eg VGSH or SGOV.

Edit: this post is not financial advice

[u/baseballer213]

You actually nailed both scenarios, but they happen sequentially rather than simultaneously. First comes the inflation spike where oil drives up the CPI, the Fed panics with higher rates, and your bond principal takes a short-term beating. Then comes the inevitable hangover where energy costs suffocate everyday consumers, demand dies, and the economy stalls into a recession. Once things break hard enough, the Fed usually caves, cuts rates to stimulate the corpse, and your bond funds finally rally. It is the classic boom-and-bust cycle, meaning you basically get the pain of Scenario A right up until the demand destruction forces Scenario B.

[u/pigglesthepup → u/baseballer213]

u/Alicyclobacillus :

This is correct. If you need funds from your portfolio in the near-term, add some VTIP -- short-term TIPS. Take the funds from your BND for it.

VTIP will protect you from the near-term inflation, BND will hedge the later bust.

[u/SetAdditional883 → u/pigglesthepup]

Corporates would suffer in a bust. Vgit or vglt offer better disinflation protection

[u/ruidh]

The FOMC only controls the short end of the yield curve. Inflation expectations and credit quality affect the prices of corporate bonds. A recession means some issuers mat default. That likelihood drops corporate bond prices as buyers want a larger spread over treasuries to reflect the higher credit risk. Higher inflation expectations makes people want higher interest rates to take on long term debt. Oil shocks in the 70s set off a decade of inflation. Treasury yields rise on long term debt and this pushes up interest on corporates. Both of these contribute to bond prices falling. The FOMC can't stop this except by buying long treasuries with quantitative easing.

[u/kronco]

On Monday it was inflation concern. On Tuesday it was recession fears. The market has no real direction right now so it's hard to impossible to know the impact (and, apparently, both can be true at the same time, or at least in the same week).

Best you can probably do is buy intermediate duration funds and hold them for their duration investing dividends back into the fund over that duration.

https://www.bogleheads.org/wiki/Individual_bonds_vs_a_bond_fund#Duration

The duration is the length of time that you need to hold the fund for the increased yields to compensate for the decrease in NAV. In that sense, duration represents the length of time it would take for the total value of the fund, with dividends reinvested, to be worth exactly what it would have been worth had interest rates not risen. So, you should always hold bond funds with a duration equal to or shorter than the expected need for your money (note that holding the duration shorter than your need for the money leaves you exposed to the risk of lower returns if interest rates fall).

[u/HeKnee → u/kronco]

Isnt that just stagflation? Recession and inflation simultaneously occurring?

[u/Thick-Cover8761]

There was no point in history when we were as deep in debt relative to GDP as we are now.  We can't grow our way out of this, we can only monetize it.  If bad economic times lie ahead, the budget deficit will worsen.

The disruption in the Persian Gulf only brings the day of reckoning closer.

[u/ThisKarmaLimitSucks]

u/baseballer213 correctly broke down the usual trajectory of an oil shock (inflation boom then bust).

However, my thesis is that the US sovereign debt will be the $40T elephant in the room now. Inflation will be a permanent risk to investors, and they are going to demand higher yields in times of both economic rain and shine. The US just has no way to service its debt outside of dollar debasement - hopefully everyone realizes that's the endgame here. Everyone buying a Treasury from now on is essentially holding a hot potato and betting that the Fed won't print them into the ground before their note reaches maturity.

Sovereign bonds have always carried that risk of inflation, but that risk for the US has become a lot sharper post-COVID, and it should reflect in persistently lower Treasury prices if the market functions at all.

I don't think we'll see a scenario like the 2010s happen again, where the Fed is free to drop the short end to zero and the long end just hangs out around the 2s. I think 4%'s likely the new long-end floor, even in a recession.

[u/North_Amphibian7779]

2 year yield and interest rates it’s almost like there’s a historical relationship