The Opportunity to Capture Higher Yields Offsets Unrealized Losses for the Vast Majority of Bond Investors
It is fair to say it’s been some time since investors have been faced with a rising interest rate environment. The corresponding volatility we’ve seen in the bond markets can be difficult for many investors to bear.
Specifically, for those investors who use bonds as a diversifier against stocks during periods of volatility to provide an opportunity for rebalances and other strategic and tactical moves in the portfolio. However, I would encourage those same investors who very often are long-term investors in the bond markets, to view this recent volatility as an opportunity. Let's review why that is:
- Lower bond prices mean higher bond yields. Investors who hold bonds for income are pleased when prices fall because the bonds continue to pay the same interest as before. Additionally, any new bonds purchased, as old bonds mature, will pay a higher income.
- Investors who hold bonds for capital appreciation (the majority of H&A clients) should zero in on the duration of their portfolio. Let’s quickly review what duration means: a measure of the sensitivity of bonds to changes in interest rates – higher durations mean more sensitivity, and therefore more potential volatility in bond prices as interest rates change.
- At H&A, the typical client’s bond duration is currently about 3.7 years (about half the Barclays bond index). What this means is that investors whose objective is total return, should be happy when bond prices decline if they expect to be in bonds for more than 3.7 years. Why? Because the additional yield from bonds they can expect to earn in the future more than offsets the immediate capital or principal loss they’re currently experiencing from the recent bond market volatility.
Now, there is one exception to a drop in the bond markets being good news, and that is for investors who use bonds for shorter-term purposes. An example is earmarking bonds in your portfolio for medium-term expenses such as college education or a home purchase. In these examples, a drop in bond prices could have a negative impact.
If you aren’t in bonds now but are concerned due to losses this year, I encourage you to view the recent volatility as an opportunity. Getting into the bond market now means you can enjoy all the benefits of higher yields without having to suffer the capital loss borne by existing bond investors.
It is worth mentioning a “nightmare scenario” for bonds in which the Fed cannot control inflation which could lead to steep price declines. But that is a feared future loss - not a past loss - and we are confident the Fed will use all the tools in their toolbox to manage inflation prudently.
In summary, we believe bondholders should embrace the recent losses, as their long-term profits should be much higher.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
All performance referenced is historical and is no guarantee of future results. Bonds are subject to market and interest rate risk if sold prior to maturity.
Bond values will decline as interest rates rise and bonds are subject to availability and change in price