This is part five in my Bonds 101 series. If you are just joining us or want to revisit one of the topics I’ve covered, here are the four prior installments:
The bond market is already recovering.
Yes, rising interest rates knocked the stuffing out of bonds and bond funds in 2022. But in the following paragraphs I’ll be returning to the fundamental principal of a bond—that it is a contract—to show how bonds can be self-healing. More than that, though, I’ll try to convince you that rising interest rates are a good thing for bond investors. Then I’ll discuss the true risk that bond investors need to keep in mind: not rising interest rates but rising inflation.
- Bonds self-heal because their issuers are obligated to return your principal to you at maturity.
- Rising interest rates translate into lower prices initially, but higher levels of income win in the end.
- Inflation is the true risk to a fixed-income investor.
“Bonds, Heal Thyself!”
Repeat after me: Bonds and bond funds are self-healing.
This is an important but often overlooked characteristic of a large portion of the fixed-income markets, so let’s spend a moment here.
What does “self-healing” mean? In essence, it means that a bond’s price will eventually return to its face value.
As I explained in the first installment of this series, a bond is a contract. This means that while a bond’s price can and will move around day to day, you also know with 100% certainty (barring a default) what the price of that bond will be on a specific date in the future. That’s the maturity date, when your “contract” concludes. On that day the borrower pays bondholders the face amount of that bond.
It doesn’t matter if inflation is higher or lower, if the economy has expanded or contracted, or if the Federal Reserve is raising or lowering interest rates. None of that matters. Yes, those factors may impact the ability of the company or government to repay their debts, but they don’t change the fact that a bond is a contract telling you how much you’ll be paid, and when.
Let’s get specific for a moment. Suppose you bought a bond at par (or face value) a year ago. As interest rates have risen, its price has fallen from, say, $100 to $95. That 5% drop isn’t fun and it probably wasn’t what you were hoping for. But, as long as you hold that bond to maturity you know its price will eventually recover to $100, or par. It’ll happen gradually or all of a sudden when you get your principal back, but you will, by contract, get your money back.
And remember, the same thing happens to all of the bonds held in a bond mutual fund or ETF. No matter what the fund manager paid for those bonds or what happens to interest rates while they hold the bonds, they will be paid back according to the terms of each contract.
Stocks simply don’t have this feature—no one is obligated to buy your stocks at a given price. That lack of a contractual guarantee is why stocks can and do fall more in price than bonds do. It’s also why they rise more in price, too!
This fundamental difference is why bonds will continue to be a reliable counterweight to stock market declines. The fact that stocks and bonds both dropped last year does not change this relationship. One year does not negate decades of experience. Give the markets a little time and the well-established relationships between broad asset classes will emerge.
Rah, Rah for Higher Rates
By now, you know that price is only one component of the bond story—income is the other that we have to keep in mind. The refrain to repeat now is: For long-term bond investors, rising interest rates are good!
After 40 years of falling interest rates and the drubbing bonds took last year as interest rates rose, you might think that sounds dead wrong. So, let me explain.
I’ll start with a simple example, and then we’ll get a little more complicated:
It’s December 2009 and I buy a 5-year Treasury bond at par ($100) yielding 2.7%. Over the next five years, that bond’s price rises and falls every day, and the U.S. government pays me interest every six months. Then, in December 2014, I get my final interest payment and my principal ($100) back. Over those five years, I turned my $100 into $114. (Technically, this assumes I could reinvest each interest payment at that initial 2.7% rate, which wasn’t the case, but let’s keep it simple.)
So, it’s December 2014 and I have $114 burning a hole in my pocket (or rather, my portfolio). I decide to buy another 5-year Treasury. Like last time, I buy it at par … only now, 5-year Treasurys yield 1.7% (down from 2.7%). Again, I receive my interest payments along the way and get my principal back at the end of the five years. After earning 1.7% per year between 2015 and 2019, I now have $124 in my account.
What I just experienced was reinvestment risk. I initially bought a bond yielding 2.7%, but when it came time to buy the next bond to reinvest the money made on my first bond, well, it was only yielding 1.7%.
Now let’s consider two scenarios assuming different yields at the December 2014 moment of reinvestment. Remember, after buying that first 5-year Treasury, it doesn’t matter if interest rates rise or fall, I’m going to have $114 in my account in December 2014 to buy another bond with.