I wish I could say with any certainty what the bond landscape will look like in the future, either short or long term. But alas, the crystal ball was yet again out of order when newsletter time rolled around. What do the “experts” think? Hard to say considering there is no general consensus. I think the only thing most people agree on is that interest rates will rise. Sometime. And as a result, existing bond prices will fall. Considering interest rates are as low as they are, and the length of time for which they have been low, it’s easy to see how these conclusions can be drawn.
Everyone is talking about the “Fed” (Federal Reserve Board). The Fed has the power to raise and lower interest rates. Their decisions on interest rates have a significant impact on the bond world. If the Fed does raise rates (possibly this year), existing bonds will lose value because new bonds will pay higher rates. For example, Trot buys a $1,000 bond that pays 3% interest. Two years later, he wants to sell the bond. In the meantime, interest rates have risen and bonds can be purchased that have a 6% rate. Because of these newer bonds paying higher rates of interest, investors won’t pay Trot as much for his bond. In fact, in this example, they would pay him roughly $500 for the bond he paid $1,000 for.
Although interest rates are the primary driver of bond prices and a major factor in overall bond performance, it probably doesn’t make sense to worry about the Fed’s next decision. Here are some historical returns to help put things in perspective: From 1948 (federal funds rate of 1.31%) to 1981 (federal funds rate of 13.42%) the average annual return on the aggregate U.S. bond market was 3.83%. So going from an extremely low interest rate environment to a very high interest rate environment, bonds still earned a positive 3.83% per year on average. Did bond returns outpace inflation over this time period? Likely no, but still they were positive. Interest rates didn’t exactly jump overnight either, taking 33 years to go from trough to peak.
When interest rates do rise, the world won’t end. The existing bonds will continue to pay whatever interest rate they were paying prior to the Fed rate hike( provided the issuer does not default. A good reason to be diversified). Bond prices will temporarily decline, but they will continue to provide diversification and stability (relative to stocks) to an overall diversified portfolio. We have prepared for this inevitable interest rate increase by using mostly active managers in the bond positions of our portfolios. Many of these managers have flexibility to seek return where they see fit. Don’t expect bonds to drive portfolio returns for the next few years, but don’t panic either.
Kirk B. Reed, CFP®
CERTIFIED FINANCIAL PLANNERTM