Photo by K. Mitch Hodge on Unsplash
You may have heard that now is not a good time to invest in bonds. With low interest rates, you don’t get much of a return. Plus, low rates today mean interest rates can only go up in the future, and you can expect bond prices to fall when interest rates rise. Some investors and analysts have declared death to the 60/40, a traditional portfolio allocation with 60 percent in stocks and 40 percent in bonds, and suggest replacing bonds with alternative investments for diversification.
The reality is that we don’t know what future bond returns will be. So before declaring death to bonds, it may be a good idea to unpack the statements above, and distinguish myth from reality.
Bond prices and interest rates
The value of a bond depends on what market investors are willing to pay to hold it. A bond has a defined payment schedule, including coupon payments and principal repayment. Investors look at the payments, evaluate their investment opportunities, and decide how much they are willing to bid for the bond. The market price depends on the value that market participants assign to the bond.
Together with the repayments, the market price determines the rate of return that investors are willing to accept on the bond. If investors bid a higher price for the same payments, they are simply accepting a lower return. If investors bid a lower price for the same payments, they are requiring a higher return on the bond. This rate of return (technically, the internal rate of return on the bond) is what many investors refer to as the yield on the bond, or simply the “interest rate.”
So there is a relationship between prices and interest rates. However, it is important to realize that prices and interest rates are jointly determined. Whatever factors lead investors to bid a higher or lower price on the bonds (or require a lower or higher interest rate), determines both prices and interest rates.
Typical factors that investors consider when valuing bonds are the economic outlook, including future inflation and interest rates, the ability of the bond issuer to repay the debt, and the time until maturity of the bond.
Today’s bond prices and future interest rates
So, do expectations about future rates influence today’s bond prices? Yes. Do investors expect future rates to be higher than today? Possibly. But, should we expect bond prices to fall in the near future if interest rates rise? The answer is we should not expect it, precisely because today’s bond prices already reflect potential future interest rate increases.
Saying that interest rates are expected to rise means that the same bond will be worth less in the future. But if investors expect that, they will lower their bids on the bond today. Today’s prices and today’s interest rates reflect the current view about future interest rates.
The biggest myth about bond returns
Here is the biggest myth about bonds: bond values will fall and bond returns will be dismal as interest rates increase. It is a myth because if it is true that interest rates are expected to rise, current prices will reflect that. And if rates do increase as expected, bond prices should not change at all!
Like the prices of all financial assets, bond prices respond to unexpected changes. If future rates rise to a higher level than expected, then bond prices may fall. But if future rates rise less than expected today, prices will rise, all else equal. Saying that you expect bond prices to fall as interest rates rise means that you expect rates to rise more than what a market already expects. Staying out of bonds based on this belief is simply market timing.
Interest rates have already increased
In case you haven’t noticed, interest rates on key bonds have increased since the late Summer of 2020. The 10-year yield went from 0.52% on August 4, 2020 to 1.74% on March 31, 2021 (see Federal Reserve Bank Data). Some of this increase was unexpected, as bond returns over this period have generally been lower than expected. The good news for investors is that bonds are relatively less expensive, now that yields are higher.
For long term investors, far from dropping bonds from their portfolio, this may be a good opportunity to rebalance out of equities, harvesting the equity gains of the initial part of the year, and into bonds at lower prices and higher yields. For long term savers, higher yields make bonds more attractive, not less.
Diversification and time in the market
Your best guess about future interest rates is that they will move (increase or decrease) in line with market expectations. There is a 50/50 chance that actual rates will rise above or below expectations, now as at any other point in time. This means your approach to asset allocation should be the same as at any other time. The first step is to tailor your bond portfolio to your investment goals. After that, diversification and time in the market are the best principles to navigate and reap the rewards of future uncertainty.
Until Next Time!
Massi De Santis is an Austin, TX fee-only financial planner and founder of DESMO Wealth Advisors, LLC. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
