Your Bond Questions Answered

Your Bond Questions Answered

May 11, 2022

Concerns about the state of the bond market abound—with good reason. This is the worst start to a year for bonds in decades. In our recent webinar, Pain, Promise and the Future of Fixed Income (click here to watch the replay), I addressed the state of fixed-income affairs. Since then, I’ve received some thoughtful questions from participants. Here are my answers.

Darryl asked: Will the Fed continue to raise rates, even into 2023?

My answer is a straightforward “maybe.” The Federal Reserve has done a good job of getting the message out that they intend to raise rates—that’s one reason why we’ve seen the bond market react the way it has. What happens next depends on a variety of factors.

“Front-end loading” (Fed Chair Jerome Powell’s words) means the Fed will be implementing larger rate hikes now. This will give the central bank the ability to make smaller rate moves or even pause their monetary policy changes down the line to reassess how the economy is responding. I believe they’ll get the response they want.

Remember, higher borrowing costs tend to cool off economic growth. Additionally, if investment markets go into a deep slump (and we’ve certainly seen some dramatic day-to-day moves lately), I would not be surprised if the Fed tones down the rhetoric and pivots to a less aggressive stance. This may mean ending the rate-hike cycle sooner with a lower fed funds rate than analysts currently anticipate. And when they do pause or end the cycle, I expect the mood of the markets to change for the better and potentially be the flashpoint that sets off a bond market recovery.

Dan wanted to know: How does the Fed setting the overnight funds rate result in changes in bond interest rates?

Let’s begin with a brief definition of the fed funds rate: Simply put, it represents the overnight lending rate between big banks. Since banks keep reserves on deposit at the Fed, the Fed sets the rate. When that rate increases, it sets off a ripple effect—the result of which is higher borrowing rates in the economy. (The same concept applies when the Fed lowers rates.) The banks then raise the interest rates they charge on loans to consumers and businesses to compensate for higher overnight rates. This eventually influences bond yields and prices.

John, Richard and Joseph all had similar questions: How do bond funds differ from individual bonds?

Bond funds—no matter if they hold ultra-short or ultra-long-maturity bonds—are designed to go on into perpetuity, meaning they never mature and return principal back to the investor. You get your money back by selling shares. With individual bonds, there is an end date when the issue matures and principal is returned to the investor.

An individual investor who holds a bond until its maturity date can be indifferent to the direction of rates. After all, changes in yields and the market value of the bond are not going to alter the locked-in terms of the bonds they hold.

As for bond funds, I believe they have positive total return prospects—even if the start to this year leads you to believe otherwise.

I can’t say exactly when interest rates will stop rising but, ultimately, they will. When they do, bond fund investors will benefit from the higher yields (and higher income) their fund produces, and possibly higher bond prices. It won’t be a simultaneous event, but you’ll be getting paid for your patience.

If you’re like me and millions of other people who make regular contributions to a 401(k) retirement plan, you’re continuously buying new bond fund shares. Right now, that’s happening at lower prices. That’s good because many of us are lowering our cost basis, receiving higher yields and more income. So even though it’s disappointing to see fund values drop, staying the course and dollar-cost averaging has benefits.

Lastly, a bond investor asked: Why do you believe the bond market has gotten a little ahead of itself this year and become oversold?

The chart below is one that I’ve used for many years, and it helps explain why I believe bonds are oversold now.

The benchmark two-year Treasury is represented by the dashed berry-colored line: When it’s rising, its price is dropping. The blue line represents the fed funds rate set by the Federal Reserve. These lines don’t always move in lockstep with each other, but what’s occurring right now is somewhat unusual. In my opinion, it shows the two-year Treasury moving too high too soon. It’s not just the size of the move but the speed at which it’s happened. This phenomenon, plus the fact that I believe the Fed’s rhetoric will not match their actions, is why I think bonds are oversold.

This chart shows the fed funds rate and the yield on the 2-year Treasury bond from May 2000 through May 2022.
Note: Chart shows two-year Treasury bond yield and the fed funds rate from 5/19/2000 through 5/6/2022. Source: Bloomberg.

The takeaway here is that bonds, especially on the short end of the maturity curve (anything two years or under), have seen their yields rise faster and higher than they have historically in response to Fed policy. Investors are seeing one- and two-year Treasury bonds with yields near or above 2%, whereas the fed funds rate just hit a range of 0.75% to 1.00% after the Fed’s 0.50% hike last week. If they’re so inclined, investors can buy shorter-term bonds and wait it out while things settle down or improve.

Whether you own individual bonds or bond funds, don’t give up on them. They’ve had a difficult start to the year, but they remain a worthy part of a diversified portfolio. I liken it to holding homeowner’s insurance despite very low odds your house will be struck by lightning on any given day.

Keep the questions coming!

 


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