Bonds in a Rising Interest Rate Environment

April 8, 2022. By J.D. Wolfsberg:

Background

Interest rates have been near record lows since the onset of the pandemic when the Federal Reserve introduced unprecedented stimulus to support the economy during a period of extreme economic uncertainty. As a result, bonds performed well as falling interest rates drove up bond prices providing investors with attractive total returns during the initial year of the pandemic.

However, as 2021 progressed inflation pressures began to build. For most of the year there was widespread belief (held by the public and the Federal Reserve) that inflation was transitory, driven to a large extent by the supply chain disruptions attributable to the pandemic. As we closed out the year, the message being conveyed by the Federal Reserve to the market began to change…no longer did it appear that inflation was transitory.  Prices were on the rise in every part of the economy and the Federal Reserve would need to raise rates.

As we entered 2022, the market began to acknowledge the ultimate direction of interest rates as inflation data continued to move higher with no indication of a pause. The Federal Reserve began to articulate its intentions to raise the Federal Funds rate and prepare investors for multiple rate increases. As a result, yields across the entire Treasury market moved higher quickly.

As we look back at the first quarter of 2022, virtually every sector in the bond market was negatively impacted.  The benchmark 10-year treasury yield rose from 1.51% to 2.34% (and now currently trading closer to 2.65%) an extremely sharp move by any measure. Consequently, the Barclays Aggregate Bond Index fell 5.93%, Municipals fell 6.23%, and High Yield fell 4.51%.*

As bond investors know, as interest rates rise bond prices fall, so as we move towards what looks to be a challenging market for bonds, we thought it would be prudent to review the impact of rising rates on investors’ portfolios and what it means for the long-term investor. As rates reset, investors are likely to experience a drawdown in their fixed income portfolios. However, unlike equities, bonds have a maturity and will pay a coupon. It is this cashflow component of bonds (or bond funds) that is critical to long term investors as yields rise.

*Municipals represented by the Bloomberg Municipal Index and High Yield by the ICE BofA High Yield Index

Portfolio Positioning

There are many factors to consider when constructing a bond portfolio. However, in a rising rate environment a key factor is Duration.   

Bond investors use the measure of Duration to quantify how much a bond’s price will rise or fall by a given move in interest rates. Therefore, duration is a measure of a bond’s price sensitivity for moves in interest rates – the shorter the duration the less sensitive – the longer the more sensitive. The calculation of duration takes into consideration the cash flows of a bond…i.e., coupon payments and maturity proceeds.

In a rising interest rate environment, it is important to focus on duration especially when considering the time horizon of the investor. An investor who has a long duration portfolio with a short time horizon runs the risk that portfolio values drop and are not recovered through the reinvestment of cashflows before the funds are required. However, for those investors who have a time horizon exceeding that of their portfolio’s duration, the reinvestment of maturities and coupons serves to reset the portfolio’s yield higher as cashflows reinvest. While the short-term impact to portfolios values is felt in both short and long duration portfolios, the shorter portfolios will be impacted less and will “reset” at a faster rate as reinvestment occurs.

While every historical period has been different, the following chart does illustrate how bonds have performed in the four preceding rising interest rate environments:

Individual Bonds and Mutual Funds

Individual Bonds – Individual bonds (the underlying in bond funds) share similar characteristics to bond funds. As discussed, the duration of an individual bond is the primary gauge to how it will react to a movement in interest rates. In a rising interest rate environment, coupon income and maturing proceeds can be reinvested at higher rates. The additional benefit to individual bonds is that as long as the bond is being held to maturity, the price changes due to rising (or falling) interest rates are mere noise as the investor will receive back their full principal at maturity (assuming no defaults). As the bond approaches maturity, its price will slowly migrate towards par value the closer and closer it gets to maturity. If an investor is buying bonds for income with the appropriate time horizon, this can offer comfort knowing that interest rate volatility will not have a substantial effect on the yield earned should the bond be held to maturity.

Mutual Funds – A bond fund manager will manage a portfolio of hundreds of bonds and publish the aggregate statistics of the bonds held in their portfolio so that investors can determine what the overall exposures are of that fund. Just like a bond, a bond fund will have a stated duration figure that gives the investor an idea of just how sensitive the fund is to the movement in interest rates. As interest rates rise, the bond fund price (or NAV) will fall depending on how much duration risk the fund carries. Recall that the longer the duration, the greater the price reaction to a movement in interest rates will be. A bond fund with a longer duration will experience a larger price decline due to rising interest rates than a shorter-dated bond fund. The drawback to bond funds is that they do not have a maturity date, so price movement will continuously affect the return to the investor. However, while this will affect returns in the short run, the benefit is that bond funds typically pay out distributions monthly. In a rising interest rate environment, as distributions are paid out, they can continuously be reinvested at higher yields as interest rates rise. This is especially true with shorter-dated bond Funds, as they will have more underlying bonds in the near term to be reinvested at higher interest rates. Bond funds also allow for the access to skilled managers with various strategies, diversification, and liquidity (trades typically settle in one business day).

Any drawdown in portfolio values is not what investors hope for, however perhaps can find ease in knowing that it may be an essential part of the process in resetting portfolio yields to higher levels. 

Should you have any questions regarding your current approach and our outlook, please do not hesitate to reach out to me directly at jdw@centerpointadvisors.net  

Disclosure: The information and analysis expressed herein is for general and educational purposes only. The information contained herein has been obtained or prepared based on sources believed to be reliable, but there can be no guarantee as to its accuracy or completeness. You should make your investment decisions based on your personal financial goals and the reward/risk level with which you feel comfortable.  Investing involves risk, including the potential for loss of principal.  Past performance does not guarantee future results. Please consult Centerpoint Advisors, LLC about your investment needs, investment objectives, risk tolerance and any changes in your life that may impact your financial objectives. This communication, along with any data or recommendation contained herein, speaks only as of the date hereof and is subject to change without notice.