A persistent feature of this recovery, today’s low interest rates, are a result of the Federal Reserve Bank’s Quantitative Easing (QE) programs. Homeowners with mortgages – at least those able to refinance their loans – have benefited from progressively lower borrowing costs (the Fed’s goal), but retirees who rely on income from CDs or other bonds aren’t at all enthused about the low rates. For investors on a “fixed income” the last several quarters have felt like a march toward less discretionary income (an unintended consequence).
One fallacy we run across routinely is bond owners hoping for rising interest rates. On the surface, this seems reasonable: if only yields rise, they’d have more income to save or spend. However, when rates rise, bond prices in fact go down, not up. This makes sense, if you think about it. Suppose you spend $1,000 to buy a 10 year bond paying $50 per year (a yield of 5%). If interest rates on 10 year bonds increase from 5% to 6% over the next year, investors will be comparatively less interested in owning your 5% bond and will adjust the price they’re willing to pay down from $1,000 as a result. The longer the time until the bond matures, the less attractive the bond is in a higher rate environment. Of course, if investors hold their bonds until maturity, they’ll get all of their money back. But sometimes the need to access bond principal in the ensuing 9 years is also a reality for investors, which means selling a bond early. Higher rates are advantageous for prospective bond buyers (or for clients with upcoming maturities that can be reinvested at higher yields), but are negative for those who already own long-maturity bonds or bond funds.
The chart below illustrates the yields of 5-year, 10-year, and 30-year U.S. Treasury bonds from 1977 to today. While there have been stretches during that time when interest rates have gone up (and bond prices down), the longer-term trend has been one toward today’s rock-bottom rates. In essence, a 35-year bull market for bonds.
Allocating a strategic amount of our clients’ portfolios to fixed income is an essential part of our discipline, though it certainly doesn’t feel good to buy bonds in today’s low interest rate environment. We prefer to keep bond investments high quality and with maturities spread over several years – typically not longer than 10 years. We structure portfolios so bonds to can be held to maturity. This approach has worked well to fix bonds in their strategic portfolio role: reliable sources of income with stable principal. A laddered portfolio of high-quality bonds also insulates bond owners from the inherent risks of higher interest rates because cash is consistently available to reinvest at higher yields.