Whats Up with Bonds?

What’s up with bonds? Well, for one thing interest rates are up and they will probably drift higher as the Powell Fed tries to “normalize” interest rates. As investors know all too well, the Federal Reserve severely suppressed interest rates between 2008 and late 2015 under the mistaken hope that low rates would stimulate the economy. (Its economists apparently forgot that for every interest rate payer there is an interest payment recipient. Retirees and pension plans paid for that folly.) Even today the Fed Funds target at 1.75% is below the rate of consumer inflation (2%). In a more normal monetary regime the Fed Funds rate would be higher than inflation. So normalization will require a further hike in interest rates.

The Federal Reserve has set in motion an upward shift in rates across the yield curve. In other words, rates are also rising for longer maturity securities such as 2 year, 5 year, and 10 year bonds. Why does that matter to investors? Because rising rates drive down the market price of existing fixed income securities.

To understand why, consider this example. On October 1, 2016 10 year U.S. Treasury bonds yielded 1.75%. Each $1000 invested provided $17.50 of coupon income annually. Eighteen months later investors could buy a newly issued 10 year Treasury with a yield of 2.75% which meant coupon income of $27.50 annually. What would an investor be willing to pay on that “old” 10 year Treasury which only pays $17.50 annually? Certainly not $1000. To match the going rate of 2.75%, an investor could only pay about $925 for the old bond. That would provide a yield to maturity of 2.75% matching that of the current “new” bond’s yield. So a 1% increase in interest rates caused a $75 decline in the market price of the old bond. That’s a 7.5% loss in market value to any investor who bought the old bond on October 1, 2016.

A natural response to the mathematics of bond investing is “Why hold any bonds in a portfolio if interest rates are going up?” Well, they do provide reliable coupon income, and they are much less subject to significant price decline than common stocks. And remember a bond held to maturity will pay off at par. That $925 bond with $17.50 coupon eventually will pay off at $1000. Another reason to hold some bonds in a portfolio is that the future is uncertain. The Fed might currently have every intention to ratchet up interest rates but economic circumstances might change. Another recession or another global financial panic could trigger a “flight to safety” which would drive down the yields (and drive up the prices) of good credit quality bonds.

Nevertheless, since prudent investing is primarily about weighing risk/return probabilities, investors can take steps to protect their bond portfolios:

1.Reduce the average maturity of fixed income investments. Intermediate bonds and bond funds (those with average maturities between 2 and 5 years) can provide decent income while exposing the portfolio to much less price risk.

2. Buy floating rate bonds which benefit from rising rates and meaningfully reduce price risk. Opportunities in that space, however, are somewhat limited because the U.S. Treasury and most states and municipalities do not issue “floaters”. Corporate issuance is concentrated in the financial sector so credit risk is hard to diversify.

3. Include various types of “alternative investments” to cushion the impact of potentially higher rates. For example, long/short equity funds, merger arbitrage funds, covered call writing programs, and specialized lending funds can provide bond-like returns while reducing or eliminating the risk from higher interest rates.

The bond market enjoyed a bull market lasting over 30 years from the interest rate peaks seen in the early 1980’s. The last 10 years were orchestrated by the central banks’ highly experimental and unproven suppression of interest rates. Capricious interventionism may be the new “wild card” of bond investing and investors must position their portfolios accordingly.

Bill Miller, CFA

Whats Up with Bonds?

What’s up with bonds? Well, for one thing interest rates are up and they will probably drift higher as the Powell Fed tries to “normalize” interest rates. As investors know all too well, the Federal Reserve severely suppressed interest rates between 2008 and late 2015 under the mistaken hope that low rates would stimulate the economy. (Its economists apparently forgot that for every interest rate payer there is an interest payment recipient. Retirees and pension plans paid for that folly.) Even today the Fed Funds target at 1.75% is below the rate of consumer inflation (2%). In a more normal monetary regime the Fed Funds rate would be higher than inflation. So normalization will require a further hike in interest rates.

The Federal Reserve has set in motion an upward shift in rates across the yield curve. In other words, rates are also rising for longer maturity securities such as 2 year, 5 year, and 10 year bonds. Why does that matter to investors? Because rising rates drive down the market price of existing fixed income securities.

To understand why, consider this example. On October 1, 2016 10 year U.S. Treasury bonds yielded 1.75%. Each $1000 invested provided $17.50 of coupon income annually. Eighteen months later investors could buy a newly issued 10 year Treasury with a yield of 2.75% which meant coupon income of $27.50 annually. What would an investor be willing to pay on that “old” 10 year Treasury which only pays $17.50 annually? Certainly not $1000. To match the going rate of 2.75%, an investor could only pay about $925 for the old bond. That would provide a yield to maturity of 2.75% matching that of the current “new” bond’s yield. So a 1% increase in interest rates caused a $75 decline in the market price of the old bond. That’s a 7.5% loss in market value to any investor who bought the old bond on October 1, 2016.

A natural response to the mathematics of bond investing is “Why hold any bonds in a portfolio if interest rates are going up?” Well, they do provide reliable coupon income, and they are much less subject to significant price decline than common stocks. And remember a bond held to maturity will pay off at par. That $925 bond with $17.50 coupon eventually will pay off at $1000. Another reason to hold some bonds in a portfolio is that the future is uncertain. The Fed might currently have every intention to ratchet up interest rates but economic circumstances might change. Another recession or another global financial panic could trigger a “flight to safety” which would drive down the yields (and drive up the prices) of good credit quality bonds.

Nevertheless, since prudent investing is primarily about weighing risk/return probabilities, investors can take steps to protect their bond portfolios:

1.Reduce the average maturity of fixed income investments. Intermediate bonds and bond funds (those with average maturities between 2 and 5 years) can provide decent income while exposing the portfolio to much less price risk.

2. Buy floating rate bonds which benefit from rising rates and meaningfully reduce price risk. Opportunities in that space, however, are somewhat limited because the U.S. Treasury and most states and municipalities do not issue “floaters”. Corporate issuance is concentrated in the financial sector so credit risk is hard to diversify.

3. Include various types of “alternative investments” to cushion the impact of potentially higher rates. For example, long/short equity funds, merger arbitrage funds, covered call writing programs, and specialized lending funds can provide bond-like returns while reducing or eliminating the risk from higher interest rates.

The bond market enjoyed a bull market lasting over 30 years from the interest rate peaks seen in the early 1980’s. The last 10 years were orchestrated by the central banks’ highly experimental and unproven suppression of interest rates. Capricious interventionism may be the new “wild card” of bond investing and investors must position their portfolios accordingly.

Bill Miller, CFA