How Today’s Bond Pain can be Viewed as Future Gain

Let’s look at rising rates as a good thing. Savers who have struggled to earn any yield either had to take on more risk to get yield, or live with the fact that relatively “safer” bonds don’t earn much. With the Fed raising rates aggressively, this has hurt anyone holding fixed-income investments. At the same time, it’s opening an investment opportunity to earn future yields on relatively “safe” investments. (Nothing is safer than FDIC-insured savings deposits, but that guarantee comes at a cost of very low yields.) Every bond investor is finding out this year that bonds are not riskless.

Interest rate risk is the component that bondholders are experiencing now. The Fed is currently raising rates to slow spending, therefore, reducing inflation to more acceptable levels. The chart below shows the impact of rate hikes on the Aggregate Bond index, which is obviously rate-sensitive. It is also important to recognize there are other components in the index such as credit and currency risks.

If interest rates rise, bondholders will experience a drop in value since the debt they are holding is paying back a lower percentage than what is available in the current market. 

For example - Say I loan out $100 at 1% interest over 10 years. The borrower will pay me $1 each year and then $100 at the end of 10 years. Now after two years, interest rates move to 5% but I’m locked in at receiving 1%. Great for the borrower, not great for me (the lender). If I wanted out of the deal, I can sell the bond but it’s not worth $100 anymore. To make up for the difference in interest, I would need to sell my bond at a discount to equal 5% interest in the eyes of the buyer, who can simply get a bond paying 5%. At the end of the loan term, the new buyer would get $100, but still get an equivalent of 5% worth of interest payments because they bought my bond at a price much lower than $100.

The difference in interest payments in that scenario is $10 originally versus $50 when interest rates rise. The biggest silver lining in all of this is bond returns are significantly more reliant on yields than price returns. Meaning the income I’m getting is more important than the price fluctuations. 

Look at the late 70s and early 80s. My example above should show a much steeper loss because rates were 4.6% in early 1977 and shot up to 15% in 1979 then peaked at 22% in 1981.

Bond investors must have been through the ringer. In 1977, the bond market set a low of -2% and ended the year up +3%. 1978, similar movements on the downside but still up positive. 1979, getting a little worse, down -7% but ended the year up 3%. 1980, down -9% and ended the year +3%. Paul Volcker came in and raised rates to 22%. Bonds returned +33% that year. 

Is a -16% sell-off warranted? Could be. Can yields go even higher? Yes. 

The bond market has not only survived more aggressive rate hikes but has thrived. Even in the teeth of the hiking cycle, bond investors still netted positive returns. 

This time could be different because we have an excess of both Fed stimulus and government stimulus. Unwinding those have unintended consequences. But historically, the bond market has been through lots of struggles. To be clear, 2022 looks like an anomaly, not the norm. 

I know it might sound counterintuitive, but bond yields are the bigger driver of returns, not price fluctuation. It isn’t fun to experience a 16% sell-off on an asset that should hold up better. But if there is a recession on the horizon, I’d rather have a 4.5% bond protecting me versus a 1% bond. 

DISCLOSURES: 

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.

Although bonds generally present less short-term risk and volatility risk than stocks, bonds contain interest rate risks; the risk of issuer default; issuer credit risk; liquidity risk; and inflation risk.

The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

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The information contained above is for illustrative purposes only.

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