FINANCIAL MARKET UPDATE 3.30.2021

AUTHOR: JOSH JENKINS, CFA

STORY OF THE WEEK

SHOULD you BE CONCERNED ABOUT THE RECENT RISE IN BOND YIELDS?

Since the beginning of the year, we have seen a rapid increase in the general level of interest rates. The widely cited 10 Year Treasury yield has nearly doubled in 2021, rising by 0.80% to 1.73% as of yesterday’s close. After delivering high single-digit returns in both 2019 and 2020, the US bond market has been under pressure as a result of the yield increase. Down 3.43% year-to-date, bonds(1) are on pace for their worst calendar year return in over forty years.

Red ink does not show up in a portfolio of high-quality investment-grade bonds very often, but when it does, investors tend to question why they own bonds in the first place. Here are a few reminders for how bonds work, how you can mitigate interest rate risk, and how investors should think about their bond allocations moving forward.

Why Rate Moves Impact Bond Prices

If you find yourself reading an article about bonds in the Wall Street Journal (or similar pub), you are virtually guaranteed to see a statement similar to: bond prices move inversely with rates. This is a concise way to explain that when yields rise, you should expect bond prices to fall and vice versa. To understand why this is the case, the following is a simplified example.

A company needs to borrow money, so it issues a 10-year bond that pays interest of 3%. The 3% interest payment, referred to as the ‘coupon,’ is set by prevailing interest rates at the time of issuance and is often fixed over the life of the bond. Let’s assume that a few years after the company sold its bonds to investors, prevailing interest rates increased from 3.0% to 4.0%. The investors that purchased the bond now face a problem. Their investment is only paying a 3.0% coupon, while other new bonds are paying 4.0%. The investors are missing out on higher interest payments, but they can’t sell their bond at full face value because nobody wants their crappy 3.0% bond. To entice somebody to buy the bond, the original investors must lower the price. In simple terms, the price will fall to the point that the fixed coupon payment divided by the bond price will equal the prevailing market interest rate. The opposite holds true if the prevailing market rate were to fall below the fixed coupon. In that scenario, the investors that held the 3.0% coupon bond would be earning more interest than newly issued bonds and could sell it to another investor at a premium.

Mitigating Interest Rate Sensitivity

The sensitivity of bonds to interest rate movements can be illustrated by a measure known as duration. As a general rule of thumb, a 1.0% move in interest rates will move the value of the bond by an amount equal to its duration. Generally, a bond with a duration of three will see its value rise/fall 3.0% for a 1.0% decrease/increase in interest rates. This concept can be applied to individual bonds, bond funds, and portfolios comprised of individual bonds and bond funds. Investors concerned about rising rates can mitigate that risk by lowering the duration of their portfolio. For reference, the Bloomberg Barclays Aggregate Bond Index has a duration of about six.

Another way to mitigate a portfolio’s interest rate sensitivity is to diversify the types of bonds held. Allocating to international bonds can be an effective way to do this, as interest rates in other countries do not move in lock-step with US rates. Treasury Inflation-Protected Securities (TIPS) offer another avenue for diversification, as their prices respond to changes in real yields, as opposed to nominal yields, and those yield movements are not perfectly correlated.

Other options for mitigating interest rate risk generally focus on ‘bond substitutes.’ This category includes utility stocks, REITs, preferred stocks, business development companies (BDCS), master limited partnerships (MLPS), and certain options strategies. Each of these alternatives suffers from some combination of:

  • Substantially higher volatility compared to high-quality bonds
  • Similar interest rate sensitivity to bonds
  • Higher correlation with stocks

There is no Substitution

For most investors, the bond allocation’s primary role is to provide portfolio stability. High-quality bonds with a short to intermediate duration carry substantially less volatility than stocks. For context, the US bond market’s(1) worst calendar year return over the past forty years was -2.92% (1994). Granted, interest rates have steadily declined in recent decades, so it would not be unreasonable to believe the road ahead could be bumpier. Still, the stock market frequently experiences volatility on a scale several magnitudes higher than bonds and will likely continue to do so in the future even if rates were to migrate higher.

When considering investment risk, it is critical to evaluate the portfolio as a whole. Bonds have a low and sometimes negative correlation with stocks. This means the price of bonds will often zig when an investor’s stock portfolio is zagging. The result can be a dramatic reduction in the fluctuation of a portfolio’s value, and the diversification benefit delivered by bonds generally increases with a higher duration. Investors seeking to eliminate interest rate risk in their bond allocation may increase their overall portfolio risk. As the portfolio’s stabilizers (bonds) are removed, the dominant driver of overall portfolio risk (stocks) goes unchecked.

While it may be uncomfortable, there are a couple of reasons investors should accept interest rate risk, even if that means a portion of their portfolio will continue to be under pressure. First, at least part of the rise in rates may be attributed to the expectation for accelerating economic growth. This is generally a positive tailwind for stocks, which can offset the weakness in bonds. Second, bonds are sometimes referred to as the self-healing asset class. When rates increase, their prices fall. That is obviously a negative, but there is also an important positive. Moving forward, interest payments received can be reinvested at higher prevailing interest rates. Over time, this can lead to a portfolio return that is actually higher than it otherwise would have been if interest rates had not moved.

1. Represented by the Bloomberg Barclays Aggregate Bond Index

WEEK IN REVIEW

  • Interest rates continue to grind higher. The ten-year Treasury is currently trading at 1.73%, around the highest level in 14 months. Mortgage rates have followed Treasuries higher, with the national average 30 year fixed mortgage rate increasing to 3.17% this week, according to Freddie Mac.
  • It’s a big week for economic data, as the Bureau of Labor Statistics publishes the payroll report on the first Friday of each month. According to MarketWatch, economists are expecting a massive increase in jobs from 379,000 in February to 675,000 in March. Other data to watch for this week include an update on the manufacturing sector for March and jobless claims on Thursday.
  • Home price appreciation accelerated to the fastest pace in 15 years during January, as the supply of homes for sale continued to decline. The S&P 500 CoreLogic Case-Shiller National Home price index showed the average home price in the 20 largest US metro areas increased by 11.1%.

HOT READS

Markets

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  • Powell Praises Economic Recovery and Sees Fed Pulling Back Help After ‘Substantial’ Progress (CNBC)
  • IMF to Raise Global Growth Forecasts on US Stimulus and Covid Vaccination Progress (CNBC)

Investing

Other

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MARKETS AT A GLANCE

Source: Morningstar Direct.

Source: Morningstar Direct.

Source: Treasury.gov

Source: Treasury.gov

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

ECONOMIC CALENDAR

Source: MarketWatch

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ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

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JOSH JENKINS, CFA + CHIEF INVESTMENT OFFICER

Josh Jenkins is the Chief Investment Officer at Lutz Financial. With 10+ years of relevant experience, he specializes in assisting clients with portfolio construction, asset allocation, and investment risk management. In addition, he is responsible for portfolio trading, investment research and thought leadership for the division. He lives in Omaha, NE, with his wife Kirsten.

AREAS OF FOCUS
  • Asset Allocation
  • Portfolio Management
  • Research & Data Analytics
  • Trading System Operation & Execution
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst®
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

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