Are Your Bonds Broken?

Chris Keith

Senior Vice President, Fixed Income Manager

There’s nothing wrong with your high-quality bonds, though I can’t blame you for thinking otherwise. Your eyes are not deceiving you—there’s red on the screen and market values have declined this month, which is frustrating to witness. Here’s my perspective on what it means and what it doesn’t.

To begin with, I don’t like watching bond prices decline any more than you do. What you’re seeing, though, is within the bounds of “normal” market behavior. Fixed-income investments—both bond funds and individual bonds—rise or fall on any given day. Right now, they’re falling. The magnitude of the move is more than many (me included) expected at this point, but this doesn’t mean your bonds are broken or have betrayed you.

The bond market is feeling the impact of rising interest rates (depicted in the table below). You know the concept by now—when rates rise, prices fall. And rates are rising because both investors and the Federal Reserve have started to take inflation seriously after ignoring it for much of last year.

Fed policy has shifted to tightening, meaning rate hikes. How aggressively the Fed acts remains to be determined. They don’t know exactly where the economy will be in the second half of the year, and they don’t want to risk financial market instability, which becomes a possibility if they overshoot on rate hikes. Right now, we’ve got one rate hike under our belts and there will soon be another.

Getting back to your bonds—here’s why I think they are not broken. They have the same characteristics as they did when you acquired them; the only change is that they are now closer to maturity. Their credit profile hasn’t weakened, so they remain high quality and are still producing income. They most likely play the same role in your investment portfolio, too. Ultimately, your bonds will do what we expect them to do.

By design, individual bonds mature at 100 cents on the dollar. Not 99 cents and not 101 cents. When you invested, you did so with a rate of return and a known maturity date locked in. Barring an outright default, you know what you’re getting and nothing has changed.

You can be certain that your bonds will “roll down the yield curve” (maturity curve)—as a four-year bond becomes a three-year bond, and so on. As a bond gets closer and closer to its maturity date, you can expect to see its price approach par value ($100). This is a dynamic that bond investors must grasp: Rising rates cause the market value—not the face value—of bonds to fall. (This plays out a little bit differently for an investor in a fixed-income mutual fund. In that case, the net asset value, or daily market price, of the fund is what you will get if you sell a share, and bond funds don’t have a maturity date or par value. That said, the individual bonds held within the fund behave as described. In addition, the manager will be reinvesting as bonds mature to keep to the fund’s mandated maturity range, risk level and income objectives.)

Bond yields are higher (and prices lower) today than they were not so long ago, and that’s contributing to the volatility we see. But over longer periods, the expectation is for bonds to continue to be less volatile than other asset classes, making them a stabilizing component of a diversified portfolio.

If you’re a bond investor, it would be a mistake to miss out on the higher bond yields we’re seeing. After all, sentiment changes, and when it does, nothing says rates can’t reverse direction and head lower. (And, as you can see in the table, you don’t have to wait 30 years to earn a good yield.)

So don’t give up on your bonds—there’s nothing wrong with them.