When investors refer to the bond market, it is usually described as being “safer” than the stock market. Bonds are generally stable and pay a fixed income. While it is true that bonds tend to be less volatile than stocks because of the fixed payments, it does not mean that they are completely immune to volatility.
There are certain factors that can impact bonds fairly significantly: inflation and interest rate changes. Unfortunately for bonds, when inflation is rising, that is often also a time when interest rates are adjusted. These two factors are the main reasons bonds have been performing poorly recently. Here’s what you should know about how inflation and interest rates impact bonds and what you should do about it.
Starting at the beginning, what is a bond? A bond is debt issued by a government, company or other entity. In exchange for loaning someone money, the lender is paid interest in addition to a promise to pay back the amount lent either over time (like a mortgage) or in a lump sum when the bond matures (like a US Treasury Bond).
The return for the lender is the interest rate the bond pays. This is typically a predetermined fixed amount (why bonds are also called fixed income) that stays the same for the life of the bond. The potential issue with this is that when interest rates increase, new investors can purchase similar-quality bonds at a higher interest rate. This in turn makes the old bonds at a lower interest rate a less attractive investment, and thus they tend to decrease in value to compensate.
Of course, the opposite is true if interest rates decrease. Current bonds are paying a higher interest rate than a new investor could receive now. This makes current bonds a better investment, so their price tends to rise in a decreasing interest rate environment.
Much of the volatility associated with the bond market right now has to do with the increasing interest rate environment. For the first time in years, the Federal Reserve increased interest rates by 0.25% in March and indicated that they anticipate increasing interest rates during each of their meetings for the rest of the year. The expected increase in interest rates is putting pressure on current bonds and is a reason why the bond market has been down recently.
Bonds and Bond Funds
The consideration of price changes between bonds and bond funds is somewhat different. As discussed above, when interest rates rise, the price of current bonds tends to drop so that the value is equitable to what you could receive from a new bond issued at a higher interest rate. When the bond market is “down,” that is referring to the market value (what you could buy or sell a bond for in the open market) of the current bonds in existence dropping in price. This impacts both bond indices and bond funds (mutual funds and exchange-traded funds) that are required to report the value of their holdings based on what they could be sold for in the open market, regardless of whether they sell the individual bonds.
This is how individual bonds differ. As an example, assume you’re the holder of a $1,000 individual bond that pays 2.5% interest and matures in five years. Interest rates increase to 3%, so your bond is not as attractive in the market. To compensate, the price of your bond drops to $900 if you want to sell it in the open market. But did you lose $100? Not unless you sell. If you continue to hold on to the bond and wait the five years for it to mature, you will still receive the $1,000 promised as part of the contract of the bond. What you give up when you hold the bond is the ability to use that money to invest in a higher interest rate bond instead.
Price changes in bonds only affect people who decide to buy or sell on the open market. When large interest rate changes occur, bond funds may drop in value in nominal terms, but the income that they’re paying typically stays similar to what they have been paying (unless the makeup of the bonds in the fund has changed substantially). Understanding the difference between what a bond is valued at versus what income it is paying out is important to understanding the role bonds may play in an investment portfolio.
The other main driver of bond valuation is inflation. The income that most bonds pay out is fixed and does not increase during the life of the bond. You’re locking in an interest rate today. Over time as the cost of goods and services increases from inflation, the income received from the bond doesn’t go as far as it used to. High inflation eats away at fixed payments and may encourage investors to purchase other investments to make up the difference.
The only way to possibly increase returns is to increase the amount of risk taken. This could mean purchasing bonds with a lower credit quality, risking that the company or government defaults and you don’t get back your principal when the bond matures. Alternatively, investing in the stock market can increase returns, and dividends tend to increase in line with inflation. However, you’re taking on more volatility in the short term, which may not align with your investment goals.
High inflation puts bondholders in a tough position and can have a negative impact on bond prices because of the relationship between using fixed payments to buy goods and inflation eroding the amount of goods you can buy with that fixed payment.
How to Manage Your Bond Portfolio
When financial planners discuss diversification (the act of spreading out your investments in numerous different kinds of companies or types of investments), they are usually referring to the stock market. While diversifying your stock holdings is crucial, it’s also important to do the same with your fixed-income investments.
Not all bonds are impacted the same when interest rates or inflation environments change. For instance, shorter-term bonds are not impacted nearly as negatively as longer-term ones when interest rates rise. This is because the money is locked into a lower-paying interest rate for less time. The investor will get the principal back sooner and can reinvest at the prevailing, higher interest rates, so the price of those bonds won’t drop as much.
As another example, TIPS (treasury inflation-protected securities) are bonds issued by the US government that adjust for inflation. So, when inflation is high, these bonds adjust accordingly and increase the return for the investor. This is a way to purchase a high-quality bond (low default risk) while still providing some inflation protection in the fixed-income portion of your investment portfolio.
Corporate bonds will provide a higher return than US government bonds because there is a greater risk that an individual company will go bankrupt than that the entire US government will. You’re trading some extra risk for extra return. These bonds are also more impacted by how the economy is doing in general because if the company goes bankrupt, it may not be able to pay back all of its obligations. So, these bonds also react differently than government bonds.
Investing in numerous types of bonds spreads out the risk, and they will perform differently in different economic situations. There are bonds that are less impacted when interest rates rise or when inflation is high. Diversifying your bonds is just as important as doing it with your stocks. Also, maintaining your target allocation between stocks and bonds is crucial for managing a prudent investment portfolio.
Bonds react to market changes just like the stock market does, but the movement tends to be less drastic. There are two factors that impact bonds more severely, though: interest rate changes and inflation. When interest rates rise and when inflation is high, it puts additional pressure on bond prices, which can cause their price to drop if you were to sell in the open market.
Just like with stocks, it’s a best practice to diversify your bond portfolio by investing in different types of bonds and not holding too many from one company. Having a well-diversified bond portfolio won’t make you immune to market fluctuations, but it can help your bond investments perform better during various market conditions.
If you need help with your overall financial plan or investment portfolio, please reach out to our team.
Nick Prigitano, CFP® is an advisor at Milestone Financial Planning, LLC, a fee-only financial planning firm in Bedford NH. Milestone works with clients on a long-term, ongoing basis. Our fees are based on the assets that we manage and may include an annual financial planning subscription fee. Clients receive financial planning, tax planning, retirement planning, and investment management services, and have unlimited access to our advisors. We receive no commissions or referral fees. We put our clients’ interests first. If you need assistance with your investments or financial planning, please reach out to one of our fee-only advisor.