Not A Happy St. Patrick’s Day for Bonds!?
Investors with exposure to bonds have been asking two primary questions. The first centers around whether current interest rate trends will continue. The second, builds upon the first and relates to future bond return expectations given the current direction of interest rates.
Question 1: Are interest rates going to continue to rise?
They could, but given the moves we have seen so far, it would be unusual to have further yield increases from this point if the equity markets continue their bull run. It is important to keep in mind that rising yields during periods of positive equity moves is a common and welcomed sign. Investors should want yields to appreciate to a more “normal” level gradually. If rates go up, investors will earn more yield in the future on their less risky investments. The pattern of yields now seems natural, even if the recent moves have felt sudden. Yields have always been volatile but tend to move in a trending direction. It seems logical to assume that the trend from here will be positive, but the recent rise in yields is significant when looking at normal short-term yield moves.
Our Take: It is likely true that, in the long-term, yields are probably going to go up. If the pace of increases is not too fast and is in combination with positive equity returns, it should be a positive development for most investors. Yields have run up considerably in the past eight months, and, so far, the impact on the markets appears to be normal and within expectations. Further evidence of this is that The Federal Reserve has taken little action during the period of yield curve normalization. Perhaps counter-intuitively, if historical trends continue, the data shows the pressure is more on a downward move in yields in the interim. But should it really matter? Let us continue to examine.
Question 2: Bonds are down 4% this year. Am I going to keep experiencing losses and what does a rise in yields mean for my investments going forward?
The relationship between yields and bond prices is well known. As yields fall, bonds go up, and vice versa. However, after experiencing an almost 40-year period of falling yields and healthy bond returns, should you be fearful of rising yields, and does it mean destruction for fixed income investments? In short, no. Rising yields in the short-term can lead to negative returns in bond portfolios, but the offset is an increase in the forward expected return in the same bonds. Bonds are simple investments; the yield on your current bond portfolio should be close to what the total return of your portfolio will be in the future. If you have experienced short-term losses, you are likely to be compensated with a greater yield in the future. There have been four occurrences in the last 25 years where the US 10 Year Treasury Yield has jumped by more than 1% in under a year. Over that time, as expected, the return on bonds was negative. However, the year immediately following the loss in price has generally been pretty good for the bonds returns. It has also coincided with strong equity markets.
Our Take: There is no free lunch in bond investing. The price of any investment, with yield or price returns, can come with short-term volatility. When looking at historical data, we are reminded that 5% bond selloffs are common. However, it is important to note two themes when the selloff happens:
- The loss of return is not a permanent impairment to the bonds’ earning potential.
- Buying newly issued bonds is more attractive than buying previously issued bonds, such as those you are holding.
While these two points may seem counterintuitive, they have been shown to be true many times prior. For example, those who held treasuries in August 2020 could have been expected to return 0.51% annually. They lost over 5% in value running up to February 2021 but may now potentially return 1.52% annually in the future. While the short-term price movements in the “safe” portion of a portfolio can be uncomfortable, investors can think of these developments as longer-term positive for their portfolio.
Further, owning some combination of fixed income and equity is a great tool to help dampen short-term pain on either side of a diversified portfolio.
Financial Advice is offered through Mid Atlantic Financial Management, Inc. (MAFM) a Registered Investment Advisor. Tempus Advisory Group is not a registered entity or a subsidiary or control affiliate of MAFM. This information should not be duplicated or distributed unless an express written consent is obtained from Tempus Advisory Group in advance. The views expressed here reflect the views of the Tempus Advisory Group Investment Committee as of 3-17-2021. These views may change as market or other conditions change. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon and risk tolerance. Past performance does not guarantee future results and no forecast should be considered a guarantee either.