Answering Questions on the Bond Market

Telemus Weekly Market Review April 18th - April 22nd, 2022

Interest rates continued their ascent this past week as comments out of Fed Chairman Jerome Powell were convincing enough for those investors that weren’t yet sold on the Fed’s willingness to take aggressive action to tackle inflation at its upcoming meetings. This resulted in a selloff for both stocks and bonds, with the S&P 500 declining -2.8% following a challenging day on Friday. Bonds also dropped, losing 1%, as prices were pressured by higher Treasury yields (bond prices move inverse of yield).

We’ve heard several opportune questions from clients about the bond market that we wanted to address in this week’s commentary.

Doesn’t the Fed control interest rates?

The Federal Reserve directly controls what is called the federal funds rate. This is the rate that banks use for overnight lending between themselves. The Fed does not directly control the rate on Treasury bonds or even mortgage rates. Treasury yields, however, incorporate expectations for future Federal Reserve actions. Hence, Treasury yields can sometimes move in advance of changes in the federal funds rate as investors begin to adjust their forecasts on the direction of future monetary policy.

Won’t bond prices continue to fall since the Federal Reserve is just starting to raise rates?

It is true the Federal Reserve has signaled that they are going to be aggressively raising rates with more significant hikes likely to come this spring/summer. However, the Fed has openly telegraphed this message and these expectations are what has led to higher Treasury yields. The 2-year Treasury yield, which more closely tracks expectations for the Fed, is up nearly two percentage points thus far this year. Thus, yields on Treasury bonds already embed roughly eight additional quarter percentage point increases in the federal funds rate over the next two years. If these expectations prove accurate, then we wouldn’t expect much additional movement in two-year Treasury yields. Given the magnitude of inflation and number of moving pieces, it’s likely that forecasts around future Fed actions continue to evolve, while will contribute additional volatility in Treasury yields.

Why own bonds?

Back in December, the consensus among the Fed’s policy setting body, the Federal Open Market Committee (FOMC), was that the Federal Funds rate would raise by 0.75% this year. As inflation has remained hot and the conflict between Russia and Ukraine has added fuel to the fire, expectations by both the Fed and market participants has evolved very quickly. This quick adjustments around inflation expectations have led to the nearly 2% increase in yield on the two-year Treasury bond.

Since bond prices fall when interest rates rise, this has resulted in declines in bond prices. While there were expectations for higher interest rates in 2022, few had expected such an aggressive rise in rates in the first four months of this year. If the Fed’s prediction of only 0.75% increase in rates had proved accurate, some investors would have been able to weather the year with a positive return (depending on their portfolios structure).

The nature of a bond is that if you buy it when its issued and hold it to maturity (and the issuer doesn’t default), then you will receive your principal back along with interest. So, in a year like 2022 rising rates will lead to lower prices. However, over time, the bond’s price will gradually revert back to its principal value by maturity.

For example, if you bought a five-year U.S. Treasury bond for $1,000 at the end of 2021. Given that yields are now higher, that bond may be worth $900 today. Over time as the bond gets closer to its maturity in December of 2026 its price will work back toward its $1,000 principal value. You would continue to collect semi-annual interest (or coupon) payments, along the way. Thus, for an investor with a short-term horizon, there will be a decline in value, but those who hold the bond through to maturity are not impacted by the change in rates (assuming the issuer does not default).

A positive of a rising rate environment for bond investors are higher reinvestment yields. As bonds mature, investors can reinvest the principal they receive into an instrument that pays a higher rate, thereby increasing their interest income. Take municipal bonds for example. At the end of 2021, a five-year AAA rated municipal bond yielded 0.60%. Today, new money investing in a 5-year AAA rated municipal bond yields around 2.50%, nearly two percentage points higher. Therefore, investors with new money or principal payments are reinvesting and a yield that is over 4x what it was at the beginning of the year. Over the long-term higher yields are going to be a benefit for buy and hold bond investors.

Do bonds no longer provide diversification and downside protection to my portfolio?

Thus far in 2022, investors have suffered from declines from both stocks and bonds in their portfolios. Looking at this from a short-term, three-month window one could argue that diversification hasn’t worked. However, decisions around diversification are based on long-term studies of asset class performance and the possibility (and frankly expectation) that there will be episodes where stocks and bonds don’t diversify one another. Going into 2022 we recognized there was a greater risk of rates rising and where appropriate included diversifying alternatives into client portfolios as well as ensured bond portfolios had less interest rate risk in an effort to improve the amount of diversification.

Where will interest rates go from here?

The dismissive answer to this question is tell us what transpires with inflation, and we will tell you what happens with interest rates. Unfortunately, no one knows the exact cadence or magnitude of inflation going forward.

At Telemus we have a well-grounded view that we nor any investor can successfully predict interest rates with consistency and accuracy. There are moments when some investors get it right, but there isn’t anyone that gets it right every time. Being aggressive with portfolios based on interest rate projections can significantly swing the risk of a portfolio and leave it dependent on a specific scenario. As such, we prefer to focus on long-term expectations and consider a range of outcomes when making decisions. We are conscious that the risk is to the upside with interest rates and hence we incorporate this perspective into the range of considerations.