How to Navigate the Amusement Park of Rising Interest Rates
It’s a centuries-old tradition that having bonds as part of a diversified portfolio is important, especially as we age. Young investors can steer clear of bonds if they’re ready to ride out stock market swings, but as we reach our 40s and beyond, it’s common, and often necessary, to inject them into the equation. But there has been recent turmoil in the bond market, also known as fixed income, due to the prospect of rising interest rates, which is important for all investors to understand. .
First, a bit of history. For those of us in our 60s and beyond, we will remember the interest rate environment of the late 70s and early 80s. Inflation was a serious blight, peaking at nearly by 14% – much worse than our current challenge and interest rates reflected it. Mortgage, bond and CD yields were in the double digits.
Then-Fed Chairman Paul Volcker made it his mission to bring inflation under control through drastic efforts by raising the federal funds rate to a peak of nearly 20%. It worked. Inflation fell dramatically in the 1980s and continued to decline globally for the next three decades.
What rising rates do to bonds
This brings us to the important but difficult topic of the impact of interest rate movements on bond portfolios. The direction of interest rate movement has the opposite effect on the value of a bond held in a portfolio. The reason is as follows: If I own a $10,000 10-year U.S. Treasury note that I bought two years ago that has a 2% yield, the value of that note and the amount another buyer is willing to pay me are directly related to what a New rating would be worth to this investor. So if that buyer of my 2% note could get a new note that only paid 1% from the U.S. Treasury, he’s willing to pay me After to get my best performance. Conversely, if that investor could buy a new note and get 3%, my 2% note is less value to them.
While the general direction of interest rates since the 1980s has been down, bond portfolios have therefore very well in terms of feedback. The Bloomberg US Aggregate Bond Index had an average annual gain of 7.41% from 1980 to 2018. The biggest decline was -2.92% in 1994. As we speak, bonds will likely have quarters harder to come. We have seen exactly that this year. For context, the Bloomberg US Bond Aggregate Index is down 7.89% since the beginning of the year until April 8, 2022.**
It is also important to note that not all bonds are created equal. There are many types of bonds, including government bonds, corporate bonds, inflation-protected securities, municipal bonds, and mortgage bonds. They can also vary in duration: some bonds are issued for a short period (one to two years), while others are issued for 30 years or more. Corporate bonds can be issued by stable companies that have less chance of default and therefore a lower yield, or by distressed companies that want to offer a higher yield to the investor, but with much more risk. A 30-year US Treasury note carries more interest rate risk than a two-year note. Well-managed funds and ETFs have recognized these trends and are positioning portfolios to try to mitigate these risks.
Does this mean that bonds are no longer an important part of a diversified portfolio? Not necessarily, but the question is topical. We need to revise our expectations and consider certain types of obligations. Increased allocations to short-term bonds, inflation-linked bonds and possibly increased cash positions are ways to recognize this challenge and reduce risk. Bonds held in mutual funds and ETFs will experience ups and downs. As interest rates rise, new bonds purchased in the funds will have a higher yield, potentially providing more return to the investor, but the transition from this low rate environment to a more reasonable plateau, regardless of either way, could be a bit rocky.
I often remind my clients that investing is an amusement park: stocks are the roller coaster, bonds are the bumper cars and whirlwinds. That is to say, they give you a feeling of unease, but not as much as the stock roller coaster. Cash, such as money market funds and savings/CDs, are the ride. Navigating between these different savings vehicles can be difficult and priorities are always changing. Knowing more about interest rates and their impact on bonds in particular can help you make well-informed and well-informed decisions.
Financial Advisor, CUNA Brokerage Services
Jamie Letcher is a Financial Advisor at CUNA Brokerage Services, located at Summit Credit Union in Madison, Wisconsin. Summit Credit Union is a $3 billion UC that serves 176,000 members. Letcher helps members achieve their financial goals and through a process that begins with a “get to know you” meeting and ends with a collaboration plan, complete with action steps.