Bond Interest Rates Demystified

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Dec 23, 2022

Bonds Series 2

When and Why Safe Doesn’t Feel Safe Anymore.

It’s been a been a challenging year for bond investors. We have not seen performance this 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. Lately, that hasn’t been the case. It comes down to interest rates.

Why are bonds experiencing bad performance?

Most of the move to date this year has been predominately 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 have been on a downtrend since the 1980’s (Baby Boomers out there remember that mortgage they got on their first house). This has been 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. Let’s just call that 0% (but at least not a negative rate like we’ve seen in Japan and certain European countries).

This is all important because the general interest rate level is like gravity. Bond prices rise and fall based on what those general interest rates are (let’s use the 10-year treasury bond as a “proxy”). When rates are declining, bond prices rise. However, when rates are increasing, bond prices go down.

For example, let’s say a bank offers an investor a one-year CD with 3% interest today, and then exactly a month later offers new buyers 4% for a new CD with the same maturity date in 11 months. If they needed to sell it, would someone buy the 3% CD for the same price?  Probably not. The buyer would either purchase the new 4% CD or ask for a price reduction on the 3% CD to offset what they could have earned had they purchased the 4% CD. The reduced price that buyer would pay for the 3% CD is what is reflected “in the red” on your investment statement (the new “fair market value”).

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 there was no way to know the bank was going to offer 4% three weeks later when the 3% CD was 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 at ideally at new higher rates. In theory, bond investors should be excited about the possibility to earn higher returns on new bond investments, assuming they have bonds that mature in the short-term and can put those funds to use.

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 the 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 now that you are locked into the lower 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. Think about it like a CD: if held 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 (which we are experiencing now), but that doesn’t change the fact that you essentially “locked in” a stream of cash flows for the duration of your holding period.
  • By holding out to call or maturity, you will get the rate of return (and a positive rate!) that you expected at the beginning.
  • A lower rate bond is less attractive if you need to sell now. We want to try to avoid that – however, the haircut on the bond sale might be worth it if you can buy a high-quality stock at an even deeper discount.
  • Bonds ultimately give you the performance at maturity that you expected if you don’t have a default along the way (thus sticking to bonds with an appropriate level of risk for your portfolio).

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.