Skip to main content

Check out our 3Q2021 Market Review & Outlook Video + Blog!

DPN Blog Banner Image Riskybusiness

Risky Business – These Are Not Your Father’s Bonds

Photo of author, David Nolan.
David Nolan
Senior Investment Strategist

Your bonds are facing challenges not seen in our lifetimes – historically low interest rates have benefitted current bondholders as their prices have risen sharply in value; but the low current rates leave bonds exposed to losses, assuming rates rise in the future. With looming massive federal deficits exacerbated by the coronavirus response by Congress and the need for future funding of expensive social programs like Medicare, Medicaid, and Social Security, it is likely that significant bond issuance by the Treasury is in the cards. This addition to the supply of Treasuries, along with possible rising inflation due to COVID-19 related supply chain shortages around the globe and a Federal Reserve that has recently increased their targeted inflation thresholds, will ultimately put pressure on interest rates to rise over time. As a result of this increase in rates, bond prices will fall leaving bond owners with losses in what they consider the “safe” portion of their investment portfolios.

Low interest rates, combined with current inflation expectations, have reduced the current “real” return (yield minus inflation) on Treasury bonds to less than zero. This means that the purchasing power of your bond investments will lose ground to inflation each year even without the principal loss associated with rising rates.

Treasury Grapch
Source: Board of Governors of the Federal Reserve System (US)




With interest rates so low, a 1% increase in the 10-yr. Treasury bond yield would result in an approximate 9% decline in the value of that bond – not something for which conservative investors would likely be prepared.

10 Yr Bond vs 6 Mo Bond

Should I sell all my bonds then?

Not necessarily. Bonds come in many forms and there are strategies that can mitigate interest rate risk. While U.S. Treasuries carry no real risk of defaulting, other bonds such as corporate bonds and tax-free municipal bonds have much higher yields than Treasuries but do have some default risk and should be reviewed carefully by investors before investing. Also, U.S. Treasury bonds behave well when investors fear economic contraction coming, such as what happened this spring, and can serve as a risk “hedge” for those investors with a heavy allocation to stocks.

To avoid the interest rate risk scenario described above, there are several strategies that can be employed:

1. Own individual bonds that mature in a specific schedule. This is known as a bond “ladder” and involves buying a series of bonds (Treasuries, corporates, or municipals) that mature each year over a certain time frame such as 10 years. This way, the investor always has a bond maturing into the higher interest rate environment and can buy a new, higher-yielding bond at the end of their ladder (e.g., buying a new 10-yr. bond when your 1-yr. bond matures).

2. Own shorter-maturity bonds and reinvest the proceeds into additional shorter-term bonds when the bonds mature. This will prevent any ultimate loss of principal but will result in lower bond yields than the laddered approach.

3. Own actively managed bond funds that buy short-to-intermediate bonds. While this strategy will involve some loss of principal in a rising rate environment, it may be mitigated by higher portfolio yields and any new money flows into the fund. These new money flows can then be used by the manager to purchase bonds that are now cheaper due to rising rates.

Conclusion

While returns on bonds will be challenged going forward, there are steps that investors can take to lessen the impact of rising interest rates on their bond portfolios. The article below from the Huffington Post further describes the risks of rising rates to your bond portfolio.

Source:

https://www.huffpost.com/entry/bond-market-risky-interest-rates_l_5daa0462e4b0422422c48495?utm_campaign=share_email&ncid=other_email_o63gt2jcad4


Related Insights
DPN blog pic

Post-COVID, Markets Prepare for Transition

The S&P 500 hit new all-time highs again in the third quarter as investors looked past a resurgence of COVID-19 cases in the U.S. and instead focused on the positive combination of a resilient economic recovery, ongoing historic support from the Federal Reserve, and strong corporate earnings. Market volatility did pick up notably during the final few weeks of September however, reminding investors that the transition to a post-pandemic “new normal” isn’t always going to be smooth. We dig deeper into performance and outline the actions we took in McKinley Carter portfolios, plus provide our best-thinking on what's ahead.

Read More
I Stock 119135127 DPN FINA Limage 800px

A Goldilocks Economy Sends Stocks to New Highs — Will the Bears Have the Last Laugh?

Looking back, the S&P 500 had a strong second quarter thanks to numerous positive developments that led to a “Goldilocks” economic environment. We dig deeper into performance and outline the actions we took in McKinley Carter portfolios, plus provide an outlook for the remainder of 2021.

Read More
Jamie street Nv W y2s O Jtc unsplash DPN article crop for CRAFT

The Light at the End of the Tunnel: Stimulus and Vaccine Optimism Power Markets Higher

The first quarter of 2021 was marked by several macro- and micro-economic surprises that resulted in increased market volatility compared to the fourth quarter of 2020, but additional economic stimulus combined with accelerating COVID-19 vaccine distribution and a decline in coronavirus cases helped stocks start the new year with solid gains. Take a look back with us at the first quarter of 2021. Review what actions we took on client portfolios as market dynamics changed. And learn what we expect for this year in our 2021 economic outlook.

Read More
Play