Investor upsides as interest rates rise
Kyle Tetting: Kendall, as the Federal Reserve raises interest rates to combat inflation, there’s no doubt that it’s caused some volatility in safer things. Things that we normally view as the safer pieces of a portfolio, things like bonds. Of course, there are plenty of challenges when the safer piece of your portfolio is bouncing around the way it has, but it’s not all bad. Maybe just start by telling us a little bit about what’s going on, a little bit of some of the challenge that’s out there right now.
Kendall Bauer: I think bond investors year-to-date have felt some pain watching rates move at a historic pace upward, and that affects the prices of the bonds they hold. A simple way to think of it is if you’re holding a bond that’s paying 2%, and the Fed raises rates and now bonds are being issued at 3% or 4%, the bond you have is worth less on the secondary market. So you’ll see that effect on the price of your bonds. Now, understand that there’s another side of the equation there. Where interest rates go up, you start to see the yield of your bond funds go up alongside with it.
Kyle: And I think understanding, of course, that bonds are a very structured product, that they have a set maturity. As long as the bond issuer doesn’t default, you’re going to get paid back the par value of the bond. And along the way, you get those stated coupon payments. You get that stated interest. So, even when bond prices decline short term, as long as the issuers are still around, you’re going to get that money back at the end – that expectation to be made whole. Of course, there are a lot of other positives about rising interest rates. As we look at bond funds, for example, there is some reason to be more optimistic about what interest looks like going forward.
Kendall: Certainly. I think if you’re holding a bond fund, rather than an individual bond, one of the things that a lot of the bond fund managers will do is take what’s called a laddered approach, meaning if you look inside of a bond fund and let’s say, for example, it has 500 or 1,000 individual bonds. Well, they’ll spread the maturities of those bonds out over various years. Then it gives them regular maturing bonds. So, in any rate environment, they can be proactive. In this case, if we’re in a rising rate environment and they have a bond that matures, now they can go out and purchase a newly issued bond at a much more attractive yield.
Kyle: And we then see the benefit of that as the interest rate that that bond fund is paying continues to rise, of course. Seeing benefits across the board from higher interest rates, the very safe pieces that investors would look to for emergency funds, for quick access to cash, we’re seeing better returns there than what we’ve seen in a very long time as well.
Kendall: Yes. A great example of that would be something like just a money market fund. You look back the last decade or so and you’re lucky to get maybe even a quarter percent. Now we’re seeing money market funds yielding sometimes north of 1%, in some cases 1.5%. For those with a more targeted time horizon, things like Treasurys and CDs look very attractive, relative to the last decade or so. Seeing rates there some cases north of 2%, 2.5%. So, yes. I think there are things to be optimistic about – even in a challenging environment for fixed income.
Kyle: And, of course, the last 10 years, stocks did most of the heavy lifting for a balanced portfolio. Bonds just didn’t have much to contribute because interest rates were so low. As we look ahead the next 10, with interest rates so higher than where they were, we can expect a little more from bonds than what we’ve seen the past 10.
Kendall: Certainly. And I don’t think it’s an excuse to abandon stocks in your portfolio. You’ve got to remember, you want to stay balanced. You want to have the right mix of stocks and bonds. That mix may be different for each individual investor based on their time horizon and investment objectives. But just because we see expected bond returns better than they have the last decade, it doesn’t give you a reason to abandon the stock side of your portfolio.
Kyle: And, of course, the reason for that is that bonds aren’t without risk. A big one for me, the inflation that we’ve heard so much and talked so much about. Inflation is a real risk for the returns on bonds.
Kendall: Certainly. And that’s just simply due to its ability to erode purchasing power. And we feel that in all areas of the markets, but it can hit bonds particularly hard. Which is another reason why, again, you want to have the right mix of stocks and bonds and not just put all your eggs in one basket.
Kyle: And of course, the key is always balance. I think understanding the role that bonds play, understanding kind of the critical nature that having that foundation plays for the balanced investor, I think, is spot on, Kendall.
Kendall Bauer is an investment advisor at Landaas & Company.
Kyle Tetting is president of Landaas & Company.
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(initially posted Nov. 23, 2022)
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