- After falling double-digits this year, bonds may now be ready to find their footing with higher interest rates.
- As interest rates rise, bond prices tend to fall which is the main reason for the current bond bear market.
- Holding a properly diversified stock & bond portfolio can yield longer-term gains despite the short-term headwinds.
Let’s dig into the two key questions after the recent bout of bond price declines. First is what just happened to the value of my “safe, less volatile” bond investments in my diversified portfolio? The second is what is the outlook for a typical 60/40 stock/bond portfolio after this kind of slump?
Investors have felt the pain thus far in 2022 with decades-high inflation and a stock market falling into bear market territory. Although larger than the well-publicized stock market1, the bond market has sneakily suffered its worst start in a half of century, surprising many investors.
Many investors own bonds in a portfolio for income, to help cushion portfolio volatility and mitigate losses during stock market drawdowns. That is, bonds tend to outperform stocks during stock market selloffs. However, this is certainly not the case in 2022 with the S&P 500 index and bonds (iShares Core Aggregate bond ETF) both experiencing double digits declines. In fact, so far this year, a 60/40 stock/bond portfolio has had its second-worst 6-month period since the 1970s as shown below.
Higher Interest Rates & Your Bond investments
If you already own bond funds or are thinking about buying bond funds you should be aware of the impact that interest rates have on the value of your bond funds. The direction of interest rates has changed significantly over the long term. Though we have experienced a significant drop in interest rates since the early 1980s, over the very long term, there have been higher and lower cycles of interest rates (see chart below).
Your Bond Fund On A Seesaw
So what happens to bond prices when interest rates move higher like this year? Bonds and interest rates have an inverse relationship, meaning when interest rates rise, bond prices typically fall and when interest rates drop, bond prices usually increase. The visual is a seesaw as the illustration below shows.
There are a number of reasons why the price of a bond changes including issuer credit risk and bond prepayments. However, the direction of interest rates can be a very important influence of a bond’s value over time.
Let’s work through an example to explain the cause of this inverse relationship between bonds and interest rates. Let’s say you own a 10-year, $1,000 bond with a coupon rate of 5%. If interest rates rise, new bond issues might have coupon rates at 6%. This means an investor can earn more interest by buying a new bond instead of your 5% coupon bond. This reduces your bond’s value, causing you to possibly sell it a discounted price.
Why Duration Matters When Bond Investing
Different types of bonds will fluctuate in value in their own way to changing interest rates. This is particularly true with a bond’s length of maturity. For example, long-term bonds fluctuate more in value than short-term bonds. This is called duration and is a measure of how much a bond’s price will likely change given a change in interest rates.
Duration Rule of Thumb: The longer the maturity of a bond, the more its value will change in relation to interest rate volatility.
To illustrate duration with a real-world investing example, see the year-to-date 2022 returns for the two Vanguard bond funds below. The long-term bond fund holds bonds with an average maturity of 24 years while the short-term fund owns bonds with an average maturity of 3 years. Thus far in 2022, with the sharp rise in bond yields, the long-term bond fund return has falling much greater than the shorter-term bond fund primarily due to the difference in duration between the bond funds.
YTD Return (as of 6/21/22)
Vanguard Long-Term Bond Index Fund (VBLLX) -24%
Vanguard Short-Term Bond Index Fund (VBISX) -5%
The Income Is Back In Fixed Income.
Along with higher bond yields means more income from bonds. Therefore, investors can now start cashing in on higher rates. Also, income from bond funds can do better in rising rate environments than in one where rates were stubbornly low (like the last decade). This is because as bonds mature in a fund, the proceeds can be reinvested in newly issued bonds with higher rates. So, while the value of a bond fund may drop in the short term because of rising rates, your return may rise over a longer period if you reinvest the higher income payments.
Keeping the long-term perspective with bond investments in a properly diversified portfolio can help investors harvest higher income and positive returns. As the chart below shows, since 1976, investors have not experienced a three-year period of losses holding stock and bonds.
Longer Term Gain After Short Term Pain
Interest rates will go up and down due to changing economic conditions and other hard to control circumstances (war, inflation etc.). Instead of trying to guess the next move in interest rates, focus on what you can control. This includes identifying bond fund investments that are appropriate for your portfolio by matching duration to your time horizon. Also knowing how much volatility you can sustain while sticking with your portfolio you need, not the one you wish you had.
David Hone, CFA
1 Source: SIFMA Capital Markets Fact Book 2021. Global bond market size is $123 trillion vs global stock market size of $105 trillion.