Bond Interest Rates Demystified: When and Why Safe Doesn’t Feel Safe Anymore

Bonds Series 2

2022 was one of the most challenging times for bond investors. We had not seen performance that bad for bonds since 1976.

Most people buy bonds with the assumption that they are “safer” than stocks; and usually when stocks are down, bonds perform well enough to offset at least some of the stock price weakness. In finance “geek-speak” we call this being negatively correlated – when one zigs, the other zags. However, that was not the case in 2022. Both stocks and bonds were down.

Why did bonds have bad performance?

First, we must point out that most of the move was related to interest rate risk (sensitivity to moves in general interest rates) rather than credit risk (sensitivity to the concern about defaulting on bond payments).

US interest rates had been on a downtrend since the 1980’s (Baby-Boomers out there, you remember that mortgage you got on your first house?). This was driven by a combination of declining inflation, declining real economic growth, and the use of “ZIRP” (zero-interest-rate-policy) in the face of some nasty economic contractions. This trend lower hit a fever pitch when the 10-year US Treasury Bond Yield reached a low point of 0.32% in March 2020.

Now, this detail is  important because the general interest rate level is like gravity – bond prices rise and fall based on what those general interest rates are. It’s what we can an “inverse” relationship:

When rates are declining, bond prices rise.

When rates are increasing, bond prices go down.

Let’s use a basic example. Say a bank offers an investor a one-year CD with 3% interest today, then exactly a month later they offer new buyers 4% for a new CD with the same maturity date in 11 months (i.e. both would pay back the buyers at the same date).  If the 3% CD investor needs the money back early, would someone buy the 3% CD for the same price?  No way. The buyer would rather purchase the new 4% CD. But they could ask for a price reduction on the 3% CD to offset what they would have earned had they purchased the 4% CD. In other words, they would make the difference by getting more principal (or face value) back than what they put in initially, or what we call a “discount.”

This isn’t fun to look at, but if we simply hold the 3% CD for the remaining 11 months, we will still earn that 3% and not actually lose money (in nominal terms).  Could we have earned more had we waited to buy?  Yes. But it would have been difficulty to know the bank was going to offer 4% three weeks later when the 3% CD was originally purchased. If the 3% rate was a good deal at the time, you collect your interest and reinvest after the CD matures in 1 year – ideally at new higher rates.  In theory, bond investors should be excited about the possibility of earning higher returns on new bond investments, assuming they have bonds that mature in the short-term and can put those funds back to use at the new higher rates.

The truth is that bank CDs aren’t “sold” early (but you can often redeem them with a small sacrifice in interest income). That’s why you don’t see values change on your bank statements when the rates change. But in principle, you are still losing money “on paper” just like bonds due to the opportunity cost of missing out on a better yielding investment. Bonds that trade on the market, in contrast, do have daily valuations that change – it’s a blessing and a curse that you can now see these new values. But at the end of the day, you need to think about it like a CD– if you hold to maturity, you are going to get the rate of return you “locked in” when you purchased the investment. No more. No less. Price changes on the statement only matter if you need to sell early.

Key Takeaways

• Prices may move (often violently) on paper, but that doesn’t change the fact that you essentially “locked in” a stream of cash flows for the duration of your holding period.
• All you need to do is keep the holding to call or maturity and you will get the rate of return that you expected at the beginning (as long as the issuer doesn’t default).

• The risk of default can be mitigated by selecting good quality issuers and diversifying (again, the reason why an experienced bond manager would be worthwhile).

While we simplify the nature of this topic for discussion, building a portfolio tailored to your investment goals can be complex. To learn more about how NPF can help you with your bond investments, or with any questions or comments, please feel free to give us a call.

Learn more in part 3 of our bond series: How to Lose Money In Bonds.

Go back to: Part 1: You’ve Got Questions, We’ve Got Answers.