What is Happening with Interest Rates and Bond Prices?

What is Happening with Interest Rates and Bond Prices?

As reported by Barron’s about a week ago, bonds had their worst quarter in years.  Bond prices across the board were down.  Mutual funds and ETFs tracking the broad bond market were down 6.5% for the quarter.  Shorter term bond funds such as those tracking one-to-three-year bonds fell about 2.6%.  Bond prices are inversely related to interest rates and inflation.  Higher inflation and interest rates lead to lower bond prices such that the bonds are priced to yield a higher rate of return depending on their maturity. The longer the bonds maturity the more sensitive it is to changes in interest rates.

Let’s examine the U.S. Treasury yield curve today versus the beginning of 2022 as shown below.

At the beginning of the year 30-year U.S. government bonds were priced to yield 2% per year (orange line). If you bought a 30-year bond from the government, you could be assured that at the end of 30 years you would have had an annual return of 2% per year (assuming that you held it to maturity). What has happened since the beginning of this year?  Higher than expected inflation. 

Inflation has been at historic low levels during the last decade (until last year) as shown in the following graphic.  Over the 1926 to 2021 period the long-term average inflation rate was 3%.  During the decade preceding 2021 it was about 2% or less.  Over the same period the average yield on 20-year U.S. Treasury Bonds was 4.9%.  Note that on average and as shown in graphic U.S. Treasury bonds have paid more than inflation.  If they did not, investors would generally not be interested in buying them as the investment would not keep up with inflation.  As inflation rises, investors in bonds demand a higher yield and bonds need to be priced to provide that higher yield.

Note the higher inflation in the last year of the graphic above.  Inflation increased coming out of the COVID pandemic due to disruptions in the global supply chain.  So why did bonds hold up very well in 2021?  This blip in inflation was not expected to be long term.  What investors care about is long-term future inflation expectations.  It was reasonable to expect that the supply chain disruptions were short-term.

Enter 2022 and the U.S. Fed’s desire to begin raising interest rates along with the invasion of Ukraine.  Sanctions on Russia and the disruption of oil and gas supplies resulting from the war have caused further inflation beyond what was expected.  At this point it is unclear how long this level of inflation will persist.

Bond yields and prices reacted.  The first graphic above shows the current U.S. Treasury curve (blue line) compared to the beginning of the year (orange line).  U.S. 30-year government bonds are now priced to yield 3% per year rather than 2%.

That is good news of sorts for those buying new bonds.  They are going to receive a higher rate of interest going forward.  Of course, they will need this higher rate to offset higher inflation if it persists. However, it is bad news for investors who were already holding bonds yielding 2%.  If they keep the bonds, they will continue to earn 2% until maturity relative to their original purchase price. However, if they want to sell the bonds early no one would be willing to pay “full price” for them since they can buy new bonds yielding 3%.  To induce them to buy the 2% bonds, current bondholders must sell them at a discount such that the new investor effectively earns 3%.  Hence, bond prices and bond funds fell in the first quarter of 2022 as inflation was higher than expected and the yield curve shifted upward to reflected needed higher interest rates.

Where do interest rates and bonds go from here? It is expected that the Fed will continue to raise interest rates, and this appears to be impounded in current bond prices.  The Fed Funds Rate is the rate set by the Federal Open Market Committee of the Federal Reserve System that banks and other institutions use when they lend money to each other on an overnight basis – hence it is a very short-term rate.  Currently this rate is a very low 0.5% (annual rate).   Polls of economists indicate an expectation of an increase to 1% at the May meeting of the FOMC and an increase to 1.5% at the June meeting.  The market appears to currently be implying a year end rate of 2.5% to 2.75% based on the futures market.  If the FOMC raised the fed funds rate to a level higher than this the bonds would react negatively.  If the do not raise interest rates by that much, then bonds could increase in value.

The same is true for inflation.  The market seems to be implying that inflation should begin to taper somewhat from the current spikes.  If data comes in showing that inflation expectations are rising bonds would react negatively. If data comes in that inflation is tapering faster than expected, then bonds could react positively.

Another factor that can come into play is a significant downturn in stock prices.  In a bear market, there is often a flight to quality where investors in the aggregate shift money from stocks to government bonds.  This drives bond prices up (and bond yields down).  This is why a diversified portfolio should include both stock and bonds. The flight to quality can moderate the decline in a portfolio in times of market turmoil (not always though as we have seen so far in 2022).

What does all of this mean for your portfolio?  We can not predict with certainty what will happen in the future.  None of us had COVID or an invasion of Ukraine in our predictions for 2020 to 2022.  Many things can happen in the future that we currently cannot anticipate.  The important concept is to have a diversified portfolio of different types of investments that matches your risk tolerance so that you are not prone to making rash decisions during market turmoil.  In times like these it may be prudent, however, to err on the side of shorter bond maturities rather than longer maturities since rising interest rates and inflation hurt long term bonds to a greater degree.  It is also a time to consider inflation protected bonds and floating rate bonds.  Once there is more certainty on long term interest rates and inflation and long-term bond yields become more attractive funds can be shifted to longer maturities.