Last summer, my family visited a popular theme park that had a wide breadth of rides – families with young kids were able to have a tranquil ride on the merry-go-round… daredevils wanting to feel what it was like to suddenly shoot 10 stories into the air between two bungy cords before bouncing up and down chose to visit a ride aptly named “The Slingshot” – there was something for everyone.
There were, however, rides that might have been misleading...
One ride in particular involved sitting in a circular car that was made to look like a teacup before gently taking off and soon coasting out of sight. To those first-time riders, it appeared they were in for a smooth, relaxing ride… only to find out that about 10 seconds in, the teacups shoot up a steep incline followed by a much steeper drop and a few inverted loops, all while spinning! Understandably, this left many riders to say to themselves, “That wasn’t at all the ride I thought I was getting on!”
Many fixed income investors are currently saying that very thing.
Fixed income (bonds) is a relatively straightforward concept – it’s a loan an investor makes to a company, government, or municipality with the expectation that the borrower will make interest payments every year for the life of the loan; then, at the conclusion of the loan period, the principal amount loaned to the borrower will be repaid to the lender. While the concept of a bond is straightforward, the risks bonds face are anything but – they can be complex and can surprise investors who don’t fully understand them.
To keep it simple, we won’t discuss all the risks bonds possess, but will instead focus on the two trends that nearly all volatility in bonds over the last year can be attributed to:
1. The Federal Reserve Bank sharply increasing the Federal Funds Rate (as a response to inflation)
2. The Federal Reserve tapering their bond buying program
Increasing the Federal Funds Rate
Below is a chart that shows the U.S. Aggregate Bond Index vs the 10 Year Treasury Rate – this chart demonstrates the inverse relationship between bond yields (orange) and the value of bonds (purple). While interest rates fluctuate in the short term, they have fallen precipitously over the last 25 years (and longer) – this has caused the value of bonds, in aggregate, to increase over that same time period. As interest rates have gone down, the value of older bonds that were issued at higher rates gain value as they possess a higher yield than newer bonds issued at lower rates.
It’s obvious that 2020 was an inflection point – the 10 year treasury rate (a derivative of the Fed Funds Rate) shot up, which caused the value of bonds to suffer a sharp decrease in value. This increase in rates is the Fed’s attempt to cool off our economy as inflation has taken off like wildfire due to uninhibited government spending for COVID relief efforts, which have totaled $4.3 billion thus far according to usaspending.gov
The Fed Has Tapered Its Bond Buying Program
The graph below, from federalreserve.gov, shows the expansion of the Federal Reserve’s balance sheet. The already bloated pre-COVID balance sheet more than doubled over the two years to $8.5 trillion! This happened because the Fed was buying over $120 billion worth of bonds a month to stave off downward price pressure in bonds during COVID. Now that the Fed has ended their buying spree, demand for new bonds has dropped off a cliff, and that will inevitably be reflected in bond values (which will go down) and yields (which will go up).
Unfortunately, poor government policies are always going to be a key risk to all financial assets. Financial markets experienced a euphoric rush from the trillions of dollars that were injected into our economy for COVID-related reasons… Now, we find ourselves paying the piper – inflation has caused the Federal Reserve to step in and attempt to cool things off by increasing interest rates and discontinuing their gawdy bond purchases, which has had a negative impact on fixed income investors.
In Conclusion
Unfortunately, many investors didn’t see this drop in fixed income coming – they thought they were boarding the docile teacup ride, only to get thrown for a loop while spinning. Without risk, there is no potential for positive returns, and many of the risks of fixed income lie around the corner and out of sight. Our job as financial planners is to educate our clients about the risks they are taking on and ensure they are getting on the proper rides.
Ultimately, an increase in interest rates will be beneficial to long-term fixed income investors as these higher-yielding bonds are added to their portfolio over time. However, staying invested in fixed income is the only way these investors will benefit from higher rates… so buckle up and try to enjoy the ride.
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