Bonds remain an important part of a balanced investment portfolio, even when the market is turbulent, and values fluctuate
Amid recent economic uncertainty, financial media coverage dwells on topics like interest rate increases, inverted yield curves, and the “bond bubble.” And many investors have shied away from bonds as this asset class has experienced a severe slump in value.
Buyers of bonds always assume a certain amount of interest rate risk. But this year, the bond market has reacted to numerous economic factors that have shaken values and many investors’ faith. While bonds and the fixed income market generally are viewed by many to be portfolio “balancers” and a surer investment than stocks, this volatile market has challenged that view.
Investors who hold bonds with the expectation they are low-maintenance assets may find themselves scrutinizing their allocations. In doing so, it’s important to understand the bond market and how its prices, rates, and yields affect each other and react to economic conditions.
This knowledge, coupled with a long-term view of bond prices and yields, typically shows that fixed income vehicles absorb price fluctuations over time, maintaining bonds as a valuable component of a diversified portfolio.
The factors influencing bond values
Two economic conditions that have recently affected the stability of bonds are rising interest rates and high inflation. An economic downturn experienced by some corporate bond issuers is also significant. These factors are all in play in 2022, as the Federal Reserve moves to curb inflation by raising interest rates, and the corporate world is still rebounding from the impact of the pandemic.
A bond’s face value is the price that will be returned to the investor upon maturity, barring a default. So if an investor intends to hold a bond until maturity, movements in the market are of lesser concern. But when investors plan to buy and sell non-mature bonds in the secondary market, economic conditions can have a dramatic impact. And adding to the complexity of bond trading in the secondary market, there’s the relationship between bond price and bond yield.
The yield, or the investor’s return on a fixed-rate bond, is determined by the price of the bond and its interest payment, or coupon (which is generally unchanged for the life of the bond). The price of a bond is inversely related to its yield; if the bond’s price goes up, its yield decreases, and vice versa. This relationship is directly impacted by what is going on in the global economy and the actions of the Federal Reserve Board.
As the SEC explains, “interest rate risk is common to all bonds, particularly bonds with a fixed rate coupon, even U.S. Treasury bonds.” When the Federal Reserve Board raises interest rates and market rates exceed a bond’s coupon rate, the prices of existing bonds tend to fall, and they are most often sold at a discount. That’s because new bonds, typically issued with coupon rates tied to the prevailing interest rate, are considered a better choice for investors. Conversely, when interest rates decline, bond prices usually increase. The bond market then offers better returns for current bondholders but, ultimately, lower returns for bonds in the future.
US investors had been experiencing historically low interest rates since 2008, the last time the Fed lowered the short-term rate to close to zero. Some observers believe it was the relative quickness (though well foreshadowed by the Fed’s bankers) and steadiness of the recent increases in rates that contributed to the turbulence in the bond market. But while the Federal Reserve influences the short-term federal funds rate and the Fed Discount Rate, bond market rates are set by issuers in the market.
The Fed historically has been moved to action because of rising inflation. Similar to interest rates, when the rate of inflation rises, bond prices tend to fall. For bonds with long maturities — for example, 30-year fixed-rate bonds — there is a greater chance that inflation will increase at some point during the bond’s lifetime. But inflation can also cause bond yields to rise, which means consistent bond investors can see heightened returns.
The health of the overall economy also impacts the bond market because bond values are tied to the creditworthiness of their issuers. Independent credit-rating agencies rate bonds. And if a credit-rating agency lowers a particular bond’s rating to reflect more significant risk, the bond’s yield typically increases, causing its price to drop.
The value of bonds in an investment portfolio
According to many analysts and economists, the bond market adheres to a set of rules and behaviors almost without exception. For example, it’s generally believed that the prices of stocks and bonds are inversely related; when stocks rally, bonds fall, and vice versa. But the opposite has happened in the last few years: stocks and bonds have periodically risen and fallen in tandem.
The bond market, long thought to be a safeguard from the market instability that plagues the stock market, has recently experienced volatility that has unnerved some investors. For some, the monetary policies of the nation’s central bankers are responsible for this uncharacteristic volatility, and they believe it will soon pass. However, others are not so sure and connect the bond market’s turbulence to signs of a pending recession.
Nevertheless, one “rule” — or, more accurately, piece of conventional wisdom — that has proven true is the value of bonds held to maturity in an investment portfolio. These returns aren’t necessarily exciting and require the sort of patience some investors lack. But they are consistent, assuming a bond weathers the risk of default. And when the markets are as volatile as they have been in the past two years, highly rated fixed-income investments held for the long term remain a prudent way to generate predictable returns. Thus, bonds can still function as a much-needed buffer from short-term volatility and serve as a valued part of a diversified portfolio.
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