Hi everyone, I’m Sarah Swan, CFP and Wealth Manager at Howe & Rusling. It’s been a tough year to be an investor in the markets, and it’s been a particularly weird one to be a bond investor. Sure, people are used to seeing the stock market behave erratically, but bonds? Those are those stable, boring things for risk-averse people, right? Well typically, yes—but this year, bond investors are asking questions they’ve never had to ask before. What does it mean that the bond market is down, or that bonds have had a historically bad year? What does that mean for me when I have bonds in my portfolio? It’s a really good, smart question, and I promise you’re going to walk away understanding the Why on a foundational level. The fact of the matter is, bonds are not exactly an intuitive animal—they are complicated to understand. We all know the usual jargon and definitions thrown around—bonds are loans, buying a bond is just lending your money to someone with the promise to get it back someday, while receiving interest along the way. And yes, all of that is true, but it doesn’t begin to explain why bond prices even fluctuate at all, and it certainly doesn’t explain why there is a relationship between bond prices and interest rates, let alone why that relationship is an inverse one. So, let’s get after it.
Typically, stocks and bonds aren’t highly correlated with each other. This makes sense—if investors are feeling like taking on risk, they’ll put their money into the stock market. Alternatively, if they’re feeling nervous, they’ll take their money and run to what feels safer—bonds, the less risky or less volatile asset class. Therefore, it’s common to see the bond market rally when the stock market is down, and vice versa. However, this year has been unique because of a little problem called inflation. This year, stocks have fallen because investors are worried about the Federal Reserve effectively throwing us into a recession, but oddly, bonds have also fallen because of the Fed’s decisions to raise interest rates to slow the economy and fix the inflation problem. But WHY? Well, let’s dive in further with an example.
Let’s say you own a $1000 US Treasury bond. This means that you lent $1000 to the US Treasury, and the Treasury is going to give you back $1000 in 10 years when the bond matures. And you knew that when you bought the bond: you knew its price, you knew its maturity date, and you knew one other thing: its coupon rate, or interest rate. Let’s say the coupon rate is 1%. This means that you’ll not only get your $1000 back in 10 years from the Treasury, but you’ll also get 1% of that $1000 face value or par value, in the form of interest, every year that you own the bond.
Well, to bring our example into real life, let’s remember that this year, the Fed has raised interest rates from near-zero at the start of the year to 4% now. And, oh by the way, new bonds have been issued all the while. These new bonds being issued look awfully similar to yours. There’s a new $1000 US Treasury bond, maturing in 10 years, except—here’s the catch. Now that exact bond will pay 3.5% in coupon interest. So, let’s think about this. If a person, let’s call her Jane, is deciding which bond to buy, is she going to want your $1000 bond that you own that pays 1% interest per year, or that other new $1000 bond that pays 3.5% interest? If Jane has a brain, she is going to want the 3.5% coupon bond. And in fact, the only way we could even get her to consider buying your bond instead would be to offer it at a pretty good “sale” price—at a discount. That way, she’ll pay less than par value for it, say, $900, and when it matures, she’ll actually get $1000 back, or $100 more than the “sale price” she paid for it. Now your bond is a little more appealing to Jane, right? Well that is exactly why interest rates and bond prices behave inversely. Because all the time there are shiny new bonds coming to market paying higher interest rates, and the only way to make up for that and keep old bonds relevant or appealing is to mark them on sale.
Okay, so what about you, then? What does it mean that the bond you bought for $1000 is now only worth $900? We’ve covered why it now has a $900 price tag, but what does that mean for you? It means that if you want to sell it to Jane, you’ll lose $100 on it—because you paid $1000 for it. BUT, if you don’t want to sell it, nothing really happens at all! You can hold onto your bond until its maturity date, and you will get the $1000 par value back that you paid for it. This is a concept that is difficult for people to wrap their heads around. You can hold onto the bond and keep receiving the same interest payments you were getting before. This is a really important concept: a bond’s coupon is guaranteed. Regardless of your bond price moving from $1000 to $900 to $950, it will always pay 1% of $1000. This means you can essentially sit back and enjoy the ride—bond prices will fluctuate, the bond market will fluctuate, but you can count on the stability of your coupon interest payments. That’s why bonds are called fixed income! Now, many find it very difficult to “enjoy” that ride, but this is what we work hard to get our bond clients to understand. As long as you do not sell your bonds when their prices are down, it is not something you have to worry about, per se. Your bonds have taken a price tag hit at the moment, but it’s merely that: a reduced price tag that only matters if the bond is in fact sold. Check your statement and you’ll see that the fixed income you were receiving in the form of semi-annual interest payments is just that: fixed, regardless of the bond’s price tag.
In summary—yes, this year, to a historically notable degree, the stability part of bonds has been challenged. Their prices have taken a serious beating, and they haven’t acted as a great alternative to stocks. But, even though their prices are down, their “fixed income” nature holds steady. And, as an aside, any bond owner who has been able to buy new bonds with available cash has been able to buy some of these shiny new bonds coming to market that we mentioned—the ones paying higher coupon rates. That’s the silver lining to rising interest rates making bond prices go down!
Thank you for sticking around to the end of this Street$marts episode to understand the relationship between bond prices and interest rates, and hopefully the bond market’s behavior this year makes more sense to you now. See you next time!