Tough Time For Bonds
Over the years, difficult periods for the stock market have invariably prompted “flights to quality” on the part of investors. In most cases, these shifts meant that funds were being moved from higher risk holdings to those appearing to offer increased safety. That usually led to a redeployment from stocks to bonds, typically those of the U.S. Treasury or high-grade corporate borrowings.
With interest rates now rising, however, that approach is no longer working. Indeed, in recent months it has backfired. In the latest calendar quarter, the Treasury market posted its worst performance in more than 40 years. For the period, the ICE 15+Year U.S. Treasury Index sustained a loss of 13%. The iShares 20+ Year Treasury Bond Index dropped 14%.
This is typical of what takes place when interest rates are rising. The rule of thumb for bonds is that when rates rise, bond prices fall. In most cases, the longer the maturity of the bonds, the greater the interim loss.
Why does this happen? Interest rates on bonds are set near prevailing rates when they are first issued. If, for example, a new bond carries an interest rate of 4% and a year later interest rates for a bond of similar maturity have climbed to 5%, the market price of the 4% bond will drop to a level at which a buyer will receive a 5% return. In this case, let’s assume that the original value of the bond was $1,000. To provide a 5% return, the value of that bond would have to drop to $800.
That’s what happens when rates are rising. During these times, bonds can be problematic investments. Of course, as bonds get close to their maturity dates their prices will move up to the face value, but there could be a very long wait and an extended span when market prices are well under purchase prices.
The sensitivity to interest rate changes is reduced as the time to maturity is shortened, but short maturities have very low returns. Current rates for U.S. Treasury securities range from only 0.7% for three-month bills to 2.8% for 10-year bonds. Higher rates are available from lower-quality issues, but the exposure to price erosion increases as the quality drops.
By comparison, the dividend yield from the Standard & Poor’s 500 Stock Index is 1.4%, not much different from that of shorter-term treasuries, but in view of the likelihood of a rebound following this year’s pullback in the stock market, flights to quality in response to current market stress would be ill-advised.
N. Russell Wayne, CFP®
Sound Asset Management Inc.
Weston, CT 06883
Any questions? Please contact me at firstname.lastname@example.org