As I have written about extensively since the Fed aggressively cut interest rates, bonds are in a tough spot. Because I continue to get questions on why I feel so strongly about the precarious nature of bond investing at current, I want to share some additional information and perspective on why I feel the way that I do. I think providing a little bond investing education here will be time well spent. Before we jump into some of the ideas, let’s be sure we have the basics down first.
Each bond or bond fund/ETF can be evaluated side-by-side using a measurement known as duration. Duration is a measure of how sensitive the price of a bond (or fund/ETF) is to a change in interest rates. Duration is measured in terms of years but is not the same thing as a bond’s maturity date. The maturity date is an important component in establishing a bond’s duration, as is the coupon/interest rate.
- As a general rule, the higher the coupon rate and/or the shorter the maturity, the shorter the duration of the bond and therefore the less sensitive the bond price will be to changes in interest rates.
- In direct contrast, the lower the coupon rate and/or the longer the maturity, the longer the duration of the bond and therefore the more sensitive the bond price will be to changes in interest rates.
Now that we understand what duration is, let’s explore how duration can be useful to us in calculating a bond’s price sensitivity to changes in interest rates.
The current 10-year Treasury Note (here-to-forward referred to as a bond) has a coupon rate of 0.625% which means if you held this bond for the full ten-year period, you would receive cumulative interest of 6.25%. Note that this interest paid is not an annual rate of return figure, but the gross return over the 10 year period as it is just 0.625 x 10 years.
If we assume the bond has a duration of approximately 9 years, we can use duration to calculate how a change in interest rates might impact its price. Using the duration of 9, if interest rates rise by 1%, we can estimate that the price of the bond should drop by approximately 9%. To arrive at this estimate, we multiply the change in rate times the duration. If rates increase by 0.5%, then the bond price will fall by about 4.5%. The opposite is also true in that if rates fall, the price would increase.
If rates increase by 1% over the coming years and the investor wants to sell their bond to move to another investment vehicle, the investor would likely lose money on the bond because they would be forced to sell it at a discount to what they paid for it. In this scenario, the only way the investor doesn’t lose money (in theory) is to hold it to maturity.
However, even that statement glosses over two very large omissions. We can’t forget that the 6.25% cumulative interest earned by holding the bond to maturity is taxable and that inflation is likely to impact the purchasing power of the principal that will be returned ten years hence.
For instance, if you purchased $10,000 of these bonds and inflation was 2% per year (the long-term stated goal of the Fed), the inflation-adjusted value of the return of your principal ten years from now would be worth approximately $8,200 in today’s dollars. Amazingly, even if we include the interest paid and held it to maturity, this bond is likely to have a negative real return as I wrote a couple of weeks back if the Fed hits their stated inflation goal.
Long story short, it’s difficult to imagine a less-inviting starting point than today for establishing a retirement bond portfolio which is why I keep harping on this idea. For these reasons, it is difficult for me to see the value of holding more fixed-income than is absolutely necessary to address short-term uncertainties.
Yet, despite these issues, it appears that investors are fleeing equities and piling into bonds because of the risk-off culture we live in. In other words, investors (speculators?) appear to be running from an asset class (the great companies of the world) that pays an income via dividends worth approximately 3X the 10-year Treasury yield TO an asset class that appears destined to get crushed by, if nothing else, inflation.
This is without even considering the fact that dividends have historically increased at twice the rate of inflation with potential capital appreciation coming along for the ride.
The fact that investors are fleeing equities must, in my opinion, be a counterintuitive bullish signal for what’s to come since the market seems to have a way of disappointing the greatest number of people.
It’s a wild world out there. I hope this helps and that you are continuing to stay the course.
Thanks for reading. I’m glad you are here.
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This post is not advice. Please see additional disclaimers.