Bonds Are Back – Part 2 (Learn to Love Them)

Categories : Financial, News
May 23, 2023

As we explained last week, ZIRP is an acronym for the Federal Reserve’s Zero Interest Rate Policy, which tends to divide Americans into winners and losers. Borrowers love cheap money, whereas investors and lenders lose their ability to earn a reasonable return on cash and other short-term investments.

Frequently heard in our office is the pejorative, “I hate bonds.” We find that investors who express that sentiment are relatively uninformed as to the purpose of holding bonds, as well as the mechanics of the bond market.

Like stocks, individual bonds are traded on an Exchange, as are Bond Mutual Funds and Exchange Traded Funds. Market prices are determined by several factors, including time to maturity, the credit quality of the issuer, and market rates of interest. Values at any moment in time are a function of these factors and are quoted in financial media and through bond brokers.

Market prices for bonds are inversely related to interest rate changes. Rising interest rates directly cause lower bond prices. Holders of bonds in a rising interest rate environment experience losses from bond price declines. Logically, the opposite is true as well. A reasonable question to ask might be, “How much do bonds change in value?” The answer is that shorter-maturity bonds incur less price change than do longer-maturity bonds.

Over time, a 64/40 portfolio (60% stocks and 40% bonds) has returned about 7% annually. However, in 2022, that portfolio mix lost 15.3% of its value. Naturally, this caused a great deal of consternation among investors, exacerbating feelings in the “I hate bonds” crowd. This is unfortunate because that drop was unusual and unexpected. So far this year (2023), the same 60/40 portfolio has gained 4.69%.

Since bond pricing rules work in both directions, investors prefer to hold longer maturity bonds while interest rates fall, in order to capture increasing values. During times of rising interest rates (as we have experienced the past few months), savvy investors shift out of longer-maturity bonds, moving their funds into short-maturity bonds, and even to money market funds. When the FED’s rate-rising cycle ends, funds get moved back into bonds with longer maturities.

The FED meeting last week produced another ¼% interest rate hike. Whether this rate increase will be the final step in our current rate-increasing cycle remains to be seen. Most market watchers seem to believe so, but there are no guarantees, so long as inflation numbers remain elevated. My guess is a short-term pause on further increases, with an uncertain future. The FED’s top priority remains a 2% maximum rate of inflation. They have a long way to go.

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