Investments

January 12, 2018 / Brian Fisher

Bonds in a Rising Interest Rate Environment

Back in 2010, I remember hearing a portfolio manager from one of the large mutual fund companies, warning about interest rate risk to bond portfolios. This was back in the infancy of the recovery and his statement was a bit premature. Since 2010, bonds as measured by the Barclays US Agg Bond Total Return have delivered a 3.61 % per year average annualized return even with five interest rate increases during the same period from the Federal Reserve.  It seems like at the beginning of every year, we hear different people make predictions, assumptions and guesses about bond prices and yields up to this point, the bond market has still provided positive returns. 

As we start the beginning of 2018 and hear the same people making predictions, we all wonder what will happen in 2018?  According to Kathy Jones, Chief Fixed Income Strategist at the Schwab Center for Financial Research, “… the Fed is on track for tightening short-term interest rates at least two or three times in 2018. This year the bond bears (could) finally awaken from their long slumber, sending Treasury bond yields above the three-year high of 2.6%,” Kathy says. “Economic growth is picking up both globally and domestically and fiscal policy is becoming more expansive. More importantly, Kathy says, the era of extremely easy money is coming to an end”

“The Federal Reserve is tightening monetary policy through rate hikes and balance sheet reduction,” Kathy says. “The European Central Bank is planning to gradually reduce its bond buying program. Even the Bank of Japan is seeing some success with positive inflation while focusing on keeping 10-year bond yields at zero or above. As the easy-money era gradually recedes, we see more upside risk in yields than downside.”

But what does this all mean for you, the investor? Let’s look at bonds, the bond market and how this affects you.

A bond is like a loan. If an entity is looking for ways to finance their activity, they may choose to issue a bond. The length of the bond will usually coincide with the length of their activity and the interest rate will depend on the current interest rate environment and their own credit rating. The US Treasury is the world’s largest issuer of bonds. Their bonds are viewed as risk-free because they are backed by the full faith of the US Government. Therefore, the interest rate (coupon) that they pay, tends to be low in comparison to other issuers. If GE wants to build a new plant to manufacture jet engines, they may issue bonds to help finance the construction of that plant. For their bonds to be attractive to investors, they will have to pay an interest rate that would be higher than a comparable US Treasury. Let’s look at an example:

As an investor, you choose to buy one of GE’s bonds. It costs $1,000, matures in 10 years and pays an interest rate (coupon) of 3.5%. Therefore, GE promises to pay you $35/year (3.5% interest on your $1,000 investment) for 10 years and at the end of that 10-year time-period, they will return your initial $1,000 investment. So, you are essentially loaning GE $1,000 for 10 years. They are paying you interest on that loan each year and after 10 years, the loan ends and they return your $1,000. Seems simple in theory and if you choose to hold onto your bond to maturity, it is. But there are certain things that will affect this bond/loan after it has been purchased.   

You see, bonds trade like stocks. In fact, the bond market is twice as big as the stock market. Whereas only corporations issue stock, governments, corporations and municipalities issue bonds. Pensions, endowments and insurance companies purchase bonds to manage their long-term liabilities, so there has always been a demand for bonds. Therefore, you may experience a decrease/increase in the price of that bond prior to maturity. Returning to our example above, suppose one year after you purchase the bond from GE, interest rates rise 1%. How does your bond compare to other bonds on the market? Since rates went up, GE is now issuing 10-year bonds with a 4.5% coupon. That means that GE is now paying $45/year interest versus the $35/year that you are currently receiving. Obviously, you want the bond with a higher coupon, but how do you get rid of your 3.5% bond? You can sell your bond in the secondary market, but it must go through a market value adjustment to be fairly priced when compared to the newly issued bonds. There would be no incentive for someone to buy your bond at its face value of $1,000 since that investor would receive less interest than the newly issued bonds. That means, you would have to sell it for less (at a discount) than your original investment of $1,000. You see, as interest rates rise, bond prices fall. This is interest rate risk.

Although the example above does not account for all the factors that affect a bond’s market price, rising interest rates will keep bonds under pressure over the coming year. At HFA, we believe that asset allocation is vital to a clients’ long-term success and bonds are often a part of that allocation. We do not make bets on the direction of interest rates, as we feel it is as difficult as predicting the direction of the stock market. In most cases, we prefer to own high quality, investment grade bonds and employ professional management to assist in the bond selection process.

If you have a question about your bonds or interest rates or want to lean more, please contact our office. We’re happy to answer your questions or provide more detail.

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