Financial Planning Focus - Bondpocalypse Now?

While equity markets have rallied since the surprise Trump victory, a rout in bond markets has been equally significant. The horror, according to bond market prognosticators, is an abrupt change in the consensus view that we are in a “lower for longer” yield environment. A Trump administration, including a Republican controlled Senate and House, are more likely to pass tax reforms and fiscal stimulus. Coupled with near full employment, these measures are likely to spur inflation as well as economic growth, though the magnitude of each will be dependent on the details of the policy changes.

The quandary bond investors face today appears to be a (now) consensus view that rates and inflation will rise in the future. Because bond investors are paid in fixed coupons and maturities, a rise in either eats away at the investor’s return. A bond holder achieves their return from interest and price appreciation, with the former typically attributing more than the latter for investment grade bonds. When prevailing rates rise, existing bonds become less valuable since newer bonds have higher yields; why pay the same price for a 2% bond when one can now buy a 3% bond? That 2% bond becomes cheaper when rates rise, but it continues to pay the same 2% coupon.

However, a drop in price can be offset with interest payments over time, and the direction of rates is almost never linear. Investors who sold their fixed income holdings during the taper tantrum in 2013 will understand this concept. According to data provided by the federal reserve bank of St. Louis, at the peak of the tantrum, treasury rates blew out to 3% on the 10-year note, only to fall down to 1.4% after Brexit in July 2016. Investors who held through this period collected both their interest and significant price appreciation.

The “this time is different” crowd points out that since rates are already so low today, the paltry amount of interest one collects over time won’t be enough to offset the loss in price. This is a valid point, but it’s worth noting the federal funds rate was at 1% at the start of the 2004-2006 cycle, and investment grade bonds returned close to 6% in total return during that period (see chart below). Contrasting this period with the surprise 1994-1995 cycle provides some perspective, in that the pace of the rate hike greatly influences whether interest payments will be able to keep up. In the 12 months between February 1994 and 1995 the federal funds rate increased 3% and the Bloomberg Barclays Aggregate, an index of investment grade U.S. debt, lost over 2%. During the 24 months from June 2004 to June 2006, the federal funds rate increased 4.25% and investment grades bond returned 6%.

In the latest cycle, we’ve seen the federal funds rate increase by 0.50% over 12 months, with a 1% increase in 2017 being the most aggressive prediction. Even with greater inflation and growth expectations, the pace of additional interest rate increases is likely to continue its slow and steady climb. This environment should allow for positive fixed income returns, albeit muted.

To avoid being Pollyannaish, let’s be clear that a rising rate environment is typically not a great situation for bond investors and low single digit returns on what likely is a significant part of many investors portfolios isn’t much to get excited about, but it isn’t the death knell that many are calling. Held through maturity, investment grade bonds can provide a steady stream of cash flow and act as a ballast during times of market stress. The horror to many investors may be owning too little fixed income when equity markets go through the next correction.