You’ve heard us preach that long-term market trends are more important than short-term movements. This idea is crucial to financial sustainability, and once again, it is tied directly to current market conditions. However, this time there is a twist – right now, it applies to fixed income positions more prominently.
Bond prices are inversely correlated to current interest rates. In plain English, this means that if you own a bond that pays 5%, and then rates increase to 6%, then your bond becomes worth less because the new bonds pay more. Rising interest rates have been a common topic of conversation for many months, and in response, bond prices have tumbled. It’s rare to see fixed income values move as swiftly as they have, but for investors who see the big picture, this is beneficial in the long haul.
In 2020, interest rates were slashed, which caused bond prices to spike – but it also resulted in bond rates moving to historic lows. That’s right – after a brief period of high returns, bonds stalled out and had no lasting, consistent returns. In 2022, the interest rate hikes have caused a sharp drop, but the enduring yield opportunities should eclipse the decline over the coming years.
Let’s craft an example.
For our base case, we will assume that an investor owns $100k worth of a specific bond that pays 1.5% (in line with our hypothetical bond rates). Then we will compare the effects of interest rate changes on the return of the given bond. For interest rate shocks, we will use an increase/decrease of 1% at some point in year 1. As with most examples, we’ll use round numbers for clarity purposes.
In the example of rates falling, the value of the bond spikes sharply in the first year, but then the coupon rates fall to the new .5% rate over time. This is commonplace for bond funds as they may choose to sell the existing bond at a premium and then plow the funds back into bonds at new rates.
In the example of rising rates, the investment value tumbles but the yearly distributions climb to significantly higher values. Again, this is not uncommon in fund management and is extremely similar to the current fixed income landscape.
From the behavioral finance perspective, the bond performance in the rising rate environment is the most challenging. Since bonds are considered a conservative investment and have a reputation for capital preservation, these changes can cause discomfort to an investor. However, the final analysis should emphasize the health of an investor’s long-term financial plan – which for many, is best with higher rates.
While this is a broad overview and doesn’t properly consider concepts such as the time value of money, the principle is clear. Over a significant time horizon, the bonds with higher coupon payments eclipse the overall return of the extremely low-yielding bonds. Rising rates cause an initial drop in the overall value of the investment. Nevertheless, for long-term investors, it is essential that bond distributions are healthy and can provide the necessary cash flow for retirement needs.
As with many investment matters, the patient and disciplined investor likely reaps the rewards. Don’t allow fleeting emotions to tamper with your probability of financial success.