How Did We Get Here?
Eighteen months ago, investment grade bond funds were yielding less than 2% whereas recently they have been yielding closer to 6%. The dramatic jump in rates is largely the result of the U.S. Federal Reserve’s actions to combat inflation, which can quite conservatively be considered the most aggressive Fed rate increase cycle of the past thirty years. Consumers and investors have had reason to be concerned: in addition to dealing with the rising cost of basic goods and services, those in the market for a home or vehicle have been confronted with skyrocketing financing costs and interest rates on credit cards have increased, piling on the pain for those who carry balances from month to month.
On top of all that, bond values fall in response to rising rates, and the corresponding decline in bond prices has been equally dramatic and painful. Those with bond investments have endured declines in a portion of their portfolio that generally doesn’t experience considerable volatility. We are all familiar with fluctuating values in our investment portfolios because it happens every day. Investment values are influenced by many variables and sometimes they go down unexpectedly, but we trust that investments with a good intrinsic value will recover and grow to new heights in the long run. That trust can be challenged, however, when economic uncertainty, geopolitical risk and other investment headwinds blow strongly, as is the case this year.
The Benefits of Higher Interest Rates
You might be thinking: inflation has started cooling but the values of some of my bond investments are still in the red, so why is this a good thing?
Unlike when equity investments go down, when faith is tested and the timing of a rebound unknown, bonds offer a clearer view of recovery in the form of increased income. The amount of income, or yield, you receive from your bond portfolio reflects prevailing interest rates over time. Now that interest rates have risen, bond investors are in a position to collect more income than prior to the rate rise, and that increased income will help to recover lost principal faster and boost total return over longer periods of time.
If you’re a long-term investor, like the vast majority of people who save so they can enjoy a financially independent retirement, then the rise in interest rates has actually been a positive development. We’re investors too, so we recognize how uncomfortable it can be when investments go down. Most investments tend to be volatile in short periods of time, but we construct portfolios for the long-term since most of us have long time horizons (for some, those time horizons even include the next generation).
So you could say we’re optimistic for the future, and that this short-term pain can lead to long-term gain. Instead of muddling along with sub-2% bond yields, the fixed income allocation in portfolios can now actually provide a meaningful stream of income which is beneficial for many reasons: higher income means you may need to draw less from principal if you’re making regular portfolio withdrawals; it takes pressure off of the equity side of the portfolio which previously had to outperform to make up for low bond yields; and it leaves bonds in an even better place to protect against a recession and/or poor equity markets.
What’s Next for Bonds and Interest Rates?
Interest rates, of course, will not go up indefinitely. There may be higher rates ahead, but at some point, the interest rate cycle will peak. If rates stay elevated, the yield on bond funds will rise over time to match the peak yields. If rates decrease, bond fund yields will begin to fall, but the value of existing bonds will appreciate, and bond fund values will rise again.
While the decline in the value of bond funds in a rising rate environment is painful, it sets up an opportunity for those same funds to produce a much higher total return in the long run.
The views expressed represent an assessment at a specific point in time, are opinions only and should not be relied upon as investment advice regarding investments, strategies, sectors or markets in general.
The above commentary has been obtained from sources we believe are reliable, but we cannot guarantee their accuracy or completeness. Past performance is no guarantee of future results. This is not a complete analysis of every material fact. All expressions of opinion are subject to change without notice.
The information contained in this document does not constitute the rendering of legal, accounting, or other professional advice or opinions on specific facts or matters. Talk to your financial advisor before acting on information in this document.