Falling Bond Prices Mean Higher Future Income

I began my career as a financial advisor in the summer of 2000.  At the end of that year the yield on the ten year Treasury bond was 5.12%.  If I had purchased a $10,000 ten year that day I would have received interest of approximately $512 per year. If I didn’t sell the security early, the government would have paid me back my $10,000 at the end of 2010.  Inflation would have reduced my purchasing power slightly but overall I would have done pretty well. Additionally, because interest rates were lower than where they started during much of the period there would have been several times that the bond could be sold for more than $10,000.  Fast forward to the recent past.  At the end of the year 2020 the ten year treasury was yielding 0.93% (having hit a low of 0.52% during the year). The Federal Reserve was in the midst of quantitative easing (purchasing securities with the goal of reducing longer term rates on mortgages, etc.) and inflation expectations were low. This means that had I purchased that $10,000 bond at the end of that year, instead of $512 my annual interest income would have been approximately $93. An 82% decline! The starting rate of the bond is the most important determination of your expected return.

Now that we have entered this new inflationary era the risk of having purchased that low interest bond is being realized.  As the interest rates on new bonds have risen, the prices on existing holdings has fallen significantly.  For example, the Vanguard Total Bond Market Fund (VBTLX), which tracks a broad index of high quality government and corporate bonds is down 14.66% over the past year through September.  This is one of the largest declines for high quality bonds in history.  This is especially painful when viewed in the portfolio context, as equity markets are also down significantly.  One of the assumed roles of having high quality bonds in your portfolio is to reduce volatility and preserve principal when the equity part of your portfolio is falling.  Historically there has been a low correlation between stocks and bonds, and in many time periods bonds have actually increased in price while stocks fell.  An example would be a recession scenario where stocks are dropping on lower earnings expectations, while interest rates are falling, thus boosting the value of high quality bonds.  This time the situation is reversed, and has led to a perfect storm for stock and bond prices.  The Federal Reserve has reacted to rapidly rising inflation by raising the Federal Funds Rate (which feeds into other short term interest rates) from near zero in March to 3.25% in September with more hikes expected.  The Fed has also switched from quantitative easing to quantitative tightening.  Mortgage rates have gone from around 3% to around 7% during this time!

Good News For New Bond Purchasers

There is a silver lining to this that is making me excited about bonds for the first time in decades.  One difficulty in helping people transition to retirement has been the low yields on “safe” investments.  It has been a conundrum in the financial planning profession.  Ideally, most retirees would prefer a steady cash flow to cover their expected living expenses.  With interest rates on low risk government bonds around 2% or below, most retirees couldn’t afford to generate the needed income from the bond portion of their portfolio.  The solutions to this conundrum carried their own additional risks.  One solution was to invest in higher yield bonds.  The tradeoff was slightly higher income with increased risk of default. In a recession it is possible your income would be reduced or some of your principal permanently lost.  Another solution was to load up on “alternative” investments such as managed futures, hedge funds, private debt, etc.  Some of these alternatives could provide a “bond like” stream of income but with much higher risk than high quality bonds. ¹  Another common solution is to hold a higher percentage of equities in the portfolio and plan to sell part of the growth on the portfolio to realize the needed cash flow.  Most planners recommended some combination of these three approaches matched to the retiree’s needs and risk tolerance. 

The good news is that with interest rates higher it is becoming possible to generate a healthy income stream from these low risk investments.  From this starting point there is more income to be had and the expected return is higher than it was when interest rates were lower.  Purchasing new bonds now will get you the higher yield right away.  As your current bonds mature you can reinvest those proceeds for higher income as well.  If you hold a bond mutual fund this is happening for you behind the scenes.  Thus, as a retiree, a time of rising interest rates is also a time of rising income.

Of course, there are several risks.  One is timing.  If inflation stays higher for longer, then even the purchasing power of this higher income will be eroded. Your real (after inflation is taken into account) return could be negative.  If we are in the early stages of a long inflationary era similar to the 1970s then total returns on bonds could be depressed for many years.  Some ways to mitigate these risks would be investing in bonds (or bond funds) with shorter maturity dates, say a mix of maturities in the 1-5 year range.  That way you will have bonds coming due regularly that can be reinvested as rates rise.  Inflation is devastating for longer term bonds, because as a lender you are stuck with the low fixed payments, which are increasingly devalued.  You could also purchase up to $10,000 in I Bonds to mitigate the inflation risk on at least part of your bond portfolio.

With a long time horizon I am more excited about high quality bonds than I have been in many years.  The higher rates go, the more compelling the future returns become.

¹ This is not to say that alternatives don’t have a place in a portfolio, just that they will have their own risk profile different from high quality bonds.