We all know bonds as a lower risk/volatile investment to their kid brother stocks. What most people don’t know is the bond market is substantially larger than the stock market. I mean like 30 trillion dollars larger! Now the reason for this post is the bond market is facing its first increase in interest rates in several years. What lies ahead are some interesting times for the bond market. I figured, why not educate on what it means and how to invest through what lies ahead.
What is a bond?
I can feel your eyes rolling at me, yea you! That said I take nothing for granted so let me start with a basic premise of what you’re buying when you purchase a bond. When you buy stocks, also referred to as equities, you’re purchasing ownership in said company. Bonds, however, are the complete opposite.
A bond is a debt instrument, typically from a governmental institution or company. This can come in various forms, whether it be the U.S. federal government, local/state governments, public corporations, foreign governments/corporations, or even pools of collateralized debt. A good example of that last one comes in the form of mortgage-backed securities, where residential or commercial mortgages are pooled together and sold to the market in the form of bond security.
What happens when you buy a bond?
When you buy a bond, you generally loan the institution your money in exchange for a fixed interest rate over a given period of time. Naturally, like a CD, the longer you are willing to lend them your money the higher the annual interest rate tends to be. At the end of the term, the borrowing institution returns your money in full.
Other factors that affect the interest rate offered would be the credit quality of the lending institution, as to entice you to take more risk on a lesser financially sound organization they must pay higher rates. The other big factor, and relevant to today’s discussion, is the going interest rate of the world’s central banks. Why you may ask? As the Federal Reserve and Treasuries are considered “risk-free”, organizations must offer better rates for you to take on “risk”.
What do rising rates mean for bonds?
Now, here comes the really interesting stuff. As the entire universe is aware that interest rates are on the rise, likely at least 6 more times this year, the natural anticipation is bond yields will increase as well. What this means is if Amazon is issuing a bond today, they may offer you it at 3%, and in a year to stay competitive they will have to offer it likely at 4-5%. Sounds great right?
Well, in the long term it is great for bond investors. As for the past bunch of years you had to take on additional risk to get more yield out of your bonds since short-term interest rates were basically zero. The issue is on the current bonds you own. You see there is what’s called an inverse relationship to bond prices when interest rates move.
Think of it like this, if today you owned a 3% Amazon bond, and tomorrow Amazon issued a 4% bond (to keep up with rising rates) what would you pay for that 3% Amazon bond? The reality in the markets is that you will still buy that 3% bond, however at a discount to what the original owner paid. This is a way to entice you to take that bond off my balance sheet. The key here is to know that markets understand this extremely well, and what we’ve seen over the last few months has been a repricing to factor in this new expectation.
How to invest in bonds?
Ok, so now that you are in on a not-so-little secret, the question is what to do about it? For starters, you absolutely can’t abandon the bond market. If you had 30% of your portfolio in bonds before, in no way am I suggesting trimming that back, as they are still a great hedge against market volatility. That said the short-term environment for bonds will be interesting as markets continually reprice expectations for where rates are going. Here are a few of our favorite ways to invest through a rising interest rate environment:
–Diversify– You knew this one was coming. Now more than ever is a great time to own a lot of different debt instruments. Corporate bonds, mortgage-backed securities, high yield, different duration bonds, etc. The key here is not putting all your eggs in one basket, as things are still unpredictable.
-Shorten the duration- Now one of the most common ways to fight through a rising interest rate is you shorten the duration of your bonds. Meaning now is the time to overload on shorter-term bonds over longer-term bonds. The theory here is, that shorter interest rate bonds are less sensitive to rising interest rates. Then when rates normalize you extend the duration and lock in longer terms bonds at higher interest rates.
-Take on more risk- Now might be the time you own not as highly rated companies as you once would have. These can be known as high yield bonds. This can be a great way to increase your yield or return.
-Floating rate debt- Now another hedge often used during this type of rising rate environment is to own some portion of floating rate debt, like the bank loan asset class. The yields on these bonds can increase as interest rates start to climb.
-TIPS- Not talking about going to a restaurant here, rather Treasury Inflation-Protected Securities. These vehicles increase as inflation increases. The natural thought here is that the reason the Fed is even raising rates is to combat inflation, and these vehicles can protect you in an inflationary time.
Time to Bond!
These are very interesting times for the bond market, and as I stated earlier no time to panic or sell out. Rather, my canned comment is you have to get creative during these times and expect some choppiness in the short term.
The silver lining? Once bonds normalize in a year or so you are likely to have a great bond market to invest in. Always remember that markets are pricing in these expectations instantaneously and won’t wait for the Fed to raise rates to move. The interesting part is, relative to three months ago, that now is a more attractive entry point to invest in bonds. In the meantime, stay the course, and know what to expect. The journey may be rocky, but the destination is bright.
Thanks and as always stay wealthy, healthy, and happy.
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