The Silver Lining of Interest Rate Increases

There are plenty of different types of bonds. They include government, corporate, municipal, mortgage, and treasury bonds.  All of them have different time frames from a couple of months to 30 years.  They all present their own risks.  For example, government, municipal, mortgage and treasury bonds are more interest rate sensitive.  This means they will move more in price when interest rates change. Corporate bonds, on the other hand, are more credit rate sensitive. That means the interest rate paid on those bonds are determined by the risk of default by the company.  That is not to say credit risk will not affect treasuries, government, mortgage or municipal bonds, or that interest rates do not affect corporate bonds, they just have a lesser impact. 

Typically, bonds and stocks move inverse of each other.  That is not as true when we are in an inflationary and rising rate environment like we are now.  Unfortunately, 2022 was a storm on all fronts and there has been almost nowhere to hide.  This has been the worst year for bonds and a 60% stock/40% bond portfolio since 1931 (The Great Depression). 

We look to position clients’ portfolios for the future rather than looking in the rear-view mirror. When it comes to bonds, we have already endured the pain of the initial and quick rise in interest rates from the Fed.  There is a silver lining though, the bonds we now hold, even though they are worth less in terms of dollar value, have seen their interest rates nearly tripled in some cases. This means clients will finally get paid for the risk of holding bonds.  For example, the yield on a typical short-term bond fund in early 2022 was slightly above 1%, it is now over 4%.  This is a huge win for those who are in the “distribution phase” of their financial lives.  This will allow the bonds to produce more income to cover withdrawals reducing the need to sell equities.  This is especially important when stocks are down so that an investor does not have to sell for losses to meet withdrawals. 

Bond prices move inverse of interest rates.  As we have seen recently, the Fed has increased interest rates and we have seen prices of current bonds fall.  This happens so that current bond coupon payments are equal to the current interest rates. Let’s consider a 10-year bond that costs $1,000 and has a 1% interest rate ($10 coupon payment) that pays annually.  If interest rates are increased to 2%, the bond that was worth $1,000 @ 1% interest rate would now have to cost $910.17 to match its yield to maturity to the current rate of 2%.

The duration of a bond (lifetime of bond) plays a large part in the price change.  The higher the bond duration the more sensitive a bond is to rate increases or decreases.  If we use the example from above and change it to a 30-year bond, holding all else constant, that bond price would drop to $776.04 with the change from a 1% to 2% interest rate.

Another factor to consider with a higher starting interest rate is that future rate increases will affect prices less (cushion). For example:

-   10-year, $1,000 par, 1% starting rate, 1% rate increase = $910.17 current value = 8.90% drop

-    10-year, $1,000 par, 5% starting rate, 1% rate increase = $926.40 current value = 7.36% drop

As a result, even if interest rates continue to rise the likelihood that a bond will produce a positive return for the year is greater due to the cushion of a higher starting rate.   

Positioning a portfolio should not be based on looking in the rearview mirror or adjusting a portfolio based upon an outlier year like 2022.  Today's higher rates will help to fund withdrawals without having to sell stocks when they are down.  Diversification of bonds between those that are interest rate sensitive and credit rate sensitive or by duration will also serve to reduce overall portfolio risk.