Owning Bonds in a Rising Interest Rate Environment

“Why would I want to own bonds right now?” – Many Clients

One of the more common questions clients have asked over the past few years is, “Why would I want to own bonds right now, when they are barely paying any interest, and interest rates are going to be going up soon?”

It’s a good question, and we’re not sure most people like the answer. Before we explore some of the responses we’ve given to this question, we should take a moment to revisit what bonds are and what is their traditional purpose for being included in someone’s investment portfolio. Most people think of stocks as the risky part of the portfolio.

They see the (sometimes) wild swings in values but put up with the volatility because of the potential for high returns. Bonds, on the other hand, are usually thought of as the boring part of the portfolio.

Historical Drawdowns in the Bond Market

In the last 25 years, the worst drawdown for the Bloomberg Barclays US Aggregate Index, think of this index as the benchmark for US bonds, similar to how the S&P 500 is a benchmark for US stocks, is about -5%. We’ve seen 5% swings in the S&P 500 in a single day. So to say bonds are usually the “boring” part of the portfolio probably isn’t too far from the truth. You can see what I mean in Figure 1 below. The bond aggregate is in purple, while the S&P 500 is in orange.

Owning Bonds in a Rising Interest Rate Environment - Bonds versus Stocks Historically

FIGURE 1 | Source: Y Charts

Bonds, Stocks, and Seesaws

One more thing about bonds. When interest rates rise, the price of bonds generally falls. Think of a seesaw, with a bond sitting on one side and interest rates on the other. Here’s the reason for this – let’s say you own a bond from a company, and that bond pays you an interest rate of 3%.

As the economy improves over time, more companies want to borrow money to expand, and there is an increase in the demand for credit. This leads to interest rates rising. The same company that issued a bond to you last year at 3% wants to borrow more money, but they need to issue new bonds at 5% because interest rates have risen. Now you have a bit of a problem.

Today’s Bond Market

Today’s bonds are paying 5%, but the bond you own is only paying 3%. Nobody wants to pay full price for your bond when they can buy a different bond with a higher interest rate, meaning there is less demand for your bond.

Lower demand generally means lower prices. Your bond has lost value. That may not be an issue if you plan to hold on to it until it matures, but if you needed to sell it for some reason, you will likely not get back as much as you paid for it. This is the problem for bond investors when interest rates are rising.

What’s Up with Interest Rates?

So what’s going on with interest rates? Are we in a rising rate scenario today?

FIGURE 2 | Source: Y Charts

By looking at Figure 2, you can tell that interest rates have been in a long-term decline for a while now. There have been brief periods where rates went up, but the trend has been lower over the last few decades. Where will rates be one year from today? What about five years?

If you ask someone this question, and they give you an answer, know that whatever they tell you is only a guess. It could be an educated guess, but it’s still their prediction and not a guaranteed outcome. You can’t predict the bond market any more than you can predict the stock market.

Having said that, let’s examine a scenario in which interest rates are going higher. What are you supposed to do with your bonds? If we know that rates going up will hurt your bond investment prices, should we sell your bonds?

In honor of college football season returning…

So, Why Would I Own Bonds in a Rising Interest Rate Environment?

One reason to own bonds in a rising interest rate environment is something we said earlier about predictions. It’s generally accepted knowledge that you can’t time the stock market. We’d also argue that you can’t time the bond market (or future changes in interest rates).

You could look at the economy today and say things are improving, and the expectation is that as the economy improves, rates should go higher. But what happens if, say in 6 months, some external forces unknown to us today cause the economy to stop growing, and we enter into a recession.

In response, the Federal Reserve cuts rates again, and there is more demand for the safety that bonds provide.

Bonds Are a Critical Part of a Well-Diversified Financial Plan

Suddenly our rising rate environment disappears faster than the Jayhawk’s chances of a bowl game. Because you can’t time the bond market, it’s best to have bonds as a component of your diversified portfolio regardless of your short-term expectations for changes in interest rates.

Bonds can also play a role in your income strategy in retirement. Granted, bonds of good quality don’t pay much income today. Maybe your income strategy in retirement relies on a combination of dividends from your stock investments and interest payments from your bond investments.

Perhaps you have a brokerage account and are interested in the tax-free income that municipal bonds can provide. No matter your income strategy, it’s worth considering having bonds as part of the big picture due to their generally stable source of income.

Note: We’re referring to US federal government bonds or high-quality corporate bonds here, not the more speculative “junk” bonds.

For more on bonds and how they can fit into your retirement portfolio strategy, you can listen to this conversation between Dean and Bud earlier this year. If you’d like to discuss your investment strategy with one of our financial planners, get in touch with us by scheduling a complimentary consultation below. You can also give us a call anytime at (913) 393-1000.

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Investment advisory services offered through Modern Wealth Management, Inc., an SEC Registered Investment Adviser.

The views expressed represent the opinion of Modern Wealth Management an SEC Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.