Bonds and Rising Rates

| August 28, 2013
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If you’ve turned on the TV lately, opened a newspaper, or even spent time on Twitter®, you’ve probably heard a lot of talk about the bond markets. Trying to make sense of all the different viewpoints and opinions you hear can be bewildering—I think of it like listening to the radio in a foreign country. You might not know exactly what they’re saying, but you’re picking up a lot of chatter about something.

For instance, here are two quotes that have dominated financial news cycles lately:

“The secular 30-yr bull market in bonds [has] likely ended …”
– Bill Gross, well-known bond investor¹

“If the economy is able to sustain a reasonable cruising speed, we will ease the pressure on the accelerator by gradually reducing the pace of [bond] purchases.”
– Ben Bernanke, Chairman of the Federal Reserve Bank²

Heard these before? If so, you’ve probably also been reading about rising interest rates and the risk they pose to bond prices. But what does it all mean? How does it affect you? I want to try to answer those questions by the time you get to the end of this letter.

Background on Bonds

For several years now, the Federal Reserve has been buying bonds at an incredible level, to the tune of $85 billion a month. $45 billion of that is going toward Treasury bonds; the rest is used to purchase mortgage bonds.³ Here’s why: since the recession, the Fed is doing everything it can to keep the economy growing. And the economy has been growing, albeit tepidly. One of the ways the Fed does this is by keeping interest rates low. Lower interest rates make borrowing less costly, which means businesses and individuals can borrow and spend more, thereby pumping more money into the economy as a whole. This, of course, equals growth.

The Fed keeps interest rates low through buying bonds, and the money it’s spending is essentially “new” money being put into circulation for the first time. So in short, think of the Fed buying bonds as if it’s trying to fill a gigantic swimming pool full of cash. The more it throws into the pool, the more is available for others to use. The more that’s available for use means the more that is available to lend … which is what keeps interest rates so low. It’s a handy short-term prop for our economy.

This prop has done a huge thing for bondholders. Lower interest rates mean higher bond prices and lower yields, which is a major benefit. But all of this is starting to change.  

What’s Happening Now

While the Fed’s aggressive bond-buying has its advantages, it also comes with risks. To buy these bonds, the government is basically just creating new money. The more it does this, the higher the risk of inflation. While inflation remains very low, the Fed has made it clear that as soon as it feels the economy can stand on its own legs, it will taper off support. Read the quote by Ben Bernanke again. As you know, Bernanke is the Chairman of the Federal Reserve. His quote from June 19th was part of a larger announcement that the Fed could stop buying bonds entirely by the middle of 2014, provided that unemployment falls to 7% or less. While 2014 is still far away, many experts think that the Fed will begin “easing the pressure on the accelerator” later this year. In other words, it could decrease the amount of money it spends on bonds very soon.

That may not seem like a dramatic announcement, but it definitely caused a lot of drama in the markets. The Dow® and S&P 500® both fell 1.4% after the statement, while bond prices also dropped, causing a simultaneous rise in yields.⁴ Of course, no one should ever react to the day-to-day tantrums of the market, and it wasn’t long before stocks started to rise again.⁵ So what’s important is not what Ben Bernanke says, or what the markets did yesterday. What’s important is the overall picture we’re getting that has become steadily clearer for a while now.

I’ll explain.

What All This Means for You

Here’s the plain and simple truth: the Federal Reserve cannot keep up its bond-buying indefinitely. Whether it stops next week or next year, it will come to an end. That means our artificially-low interest rates will go up, too. Now, it’s not going to happen all at once. And it’s not going to keep the sun from shining, so there’s no need to panic. But it will happen, so we need to adapt.

Since interest rates will go up, bond prices will go down. People have gotten used to double-digit returns when it comes to bonds and other fixed-income investments, but those days are probably coming to an end. It’s time to adjust expectations. That’s why we are currently recommending that investors consider moving out of long-term bonds, shortening their durations to decrease volatility in their portfolio. Why? Well, let’s go through a little lesson in Bonds 101.

As previously said, bond prices go down when interest rates go up. Let’s say you buy a bond for $1,000 that will mature in ten years. During those ten years, the issuer of the bond pays you 5% in annual interest. That’s $50 a year until the bond matures, in which time you get your initial investment back.

But let’s say that in those ten years, interest rates rise to 6%. Not a big deal, unless you have to sell your bond before it matures. But who would want to pay $1,000 for a bond that pays 5%, when they can buy a similar bond that pays 6%? No one would. So that means the price of your bond will fall, and the highest you can sell it for would be less than the $1,000 you initially paid. Obviously, that’s not ideal. You never want to sell something for less than you paid for it … not if you can possibly help it.

That’s why there is so much volatility in the bond markets right now. Bond investors are worried that interest rates will go up, and soon. That means their bonds will decrease in value. Now you know why there’s been so much chatter in the news lately.

So why are we recommending that investors move out of long-term bonds? Because the longer you have to wait for your bond to mature, the likelier it is that interest rates will increase. Not only that, but the interest rates at the end of a 10- or 30-year cycle could look a lot different than when you first bought the bond. So shortening maturities and moving out of long-term bonds is a very prudent move. It won’t immunize your portfolio from volatility, but it will certainly decrease your risk.

Now, what I’m not saying is that anyone should make drastic changes. Any changes you do make should be incremental. It’s important investors learn not to react to headlines, or even to quotes by the Federal Reserve chairman. Your portfolio is, and should always be, built around the fundamentals of good investing that work no matter how stormy the weather. Remember, a properly allocated portfolio removes the need to react to the day-to-day changes of the markets. (If you have questions about whether your own asset allocation is right for you, feel free to give me a call and we can discuss it together.)

To put it simply, here’s what investors should be thinking about in the coming weeks:

Bonds and many other types of fixed-income investments have had a great long run, but the environment that allowed them to flourish is coming to an end.

  • For that reason, it’s probably time to start thinking about gradually adjusting your portfolio in order to lessen your risk. This doesn’t mean you should abandon bonds entirely, only that you should be more selective in choosing them.

  • Always invest to reach specific goals, not to chase high returns. There are other opportunities for growth, and the volatility in the bond market doesn’t change that.

  • It’s important to stay educated but don’t worry too much about daily fluctuations or the latest headlines. The media makes its living by being temperamental and emotional. We don’t.

Most importantly, remember that I’m here. If you have any questions or concerns about what’s going on, or where the markets are headed, don’t hesitate to give me a call. I’d be happy to give you a second opinion on your asset allocation, or discuss some of the other financial opportunities that exist in the markets. In the meantime, please let us know if there’s ever anything we can do.

  Sources:

  1. MinZeng, “Bill Gross: Bull Market in Bonds is Over,” The Wall Street Journal, May 10, 2013. http://blogs.wsj.com/moneybeat/2013/05/10/bill-gross-bull-market-in-bonds-is-over

  2. Steve Hargreaves, “Fed sets road map for end of stimulus,” CNN, June 19, 2013. http://money.cnn.com/2013/06/19/news/economy/federal-reserve-stimulus/index.html?iid=EL

  3. Joshua Zumbrun & Jeff Kearns, “Fed Maintains $85 Billion Pace of Purchases as Growth Pauses,” Bloomberg, Jan. 30, 2013. http://www.bloomberg.com/news/2013-01-30/fed-maintains-85-billion-pace-of-purchases-as-growth-pauses.html

  4. Hibah Yousef, “Dow sinks 200 points after Fed hints at stimulus easing,” CNN, June 19, 2013. http://money.cnn.com/2013/06/19/investing/stocks-markets/index.html

  5. S&P 500, June 19th-July 11th 2013. Yahoo Finance. http://finance.yahoo.com/echarts?s=%5EGSPC+Interactive#symbol=%5Egspc;range=20130619,20130711;compare=;indicator=volume;charttype=area;crosshair=on;ohlcvalues=0;logscale=off;source=undefined;

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