After a fairly strong start to 2015 for bond market returns, interest rates have seemed to settle in lately. It’s possible that the bond market is beginning to price in a Fed Funds rate increase sometime in the near future. The chart above is a one year daily chart of the 10 year treasury interest rate index (TNX). The 10 year interest rate is close to turning positive for the year to date after being down at one point by 24%.
A measured move target comes into play at 24.50 with the year to date break even and March highs as potential deterrents. This is equated by taking the length of the rally off the February lows to March highs and adding that amount to the lows that were formed in April. It is important to note that this index is 10x the actual interest rate. So a target of 24.50 on TNX, would equate to a yield of 2.45%.
Why is this important to bond investors? I must preface that any short term movements have little if any importance to investors. However for educational purposes this “Bond see-saw” (as I’ve heard it explained as) means when interest rates rise, the market price of bond holdings decline (and vice-versa).
So let’s say for example you purchase a bond that pays 2% in interest annually. If after your purchase, rates drop to 1%, all of a sudden your bond that pays you 2% interest will look very attractive. The attractive rate will increase demand and in turn the market price of your bond will increase in market value.
Now let’s say that after purchasing your 2% bond, rates increase to 4%. In this case someone would look at your bond paying 2% and ask why they should purchase your bond when they can buy a new bond that pays them 4%. This decrease in demand will cause the market value to drop.
The consensus has suggested that rates will rise soon, the problem here is that they have been saying this for years. Interest rates will eventual move higher but no one knows the timing with any certainty.
However this market timing message I believe misses the whole point when it comes to bond investing. Bonds are there to help soften the blow when the eventually market panics settle in and to provide some fixed income that one can either use to purchase stocks on a dip or pay off expenses and liabilities. They really shouldn’t be seen as something that you jump in and jump out, or get scared out of for that matter. A bear market in bonds is quite different than a bear market in stocks.
The most important thing is to create your asset allocation that suites your time-frame, risk tolerance and temperament. It has little to do with where interest rates are currently at and where you believe they will go. A Financial Advisor can certainly help you create your personalized asset allocation plan if it feels overwhelming to you.
This chart shows the total returns for a few of the bond sectors year to date. US treasury bonds (red line) opened the year off quite well but have since entered negative territory. Corporate bonds (blue) have done a little bit better with a gain of around 0.75% year to date. While high yield or junk bonds (green) sport the best performance so far around 4% year to date. This is relatively commonplace with a somewhat rising stock market.
Stocks generally do pretty well at the beginning stages of a Fed Funds rate increase cycle. It’s usually, though not always, not until the short term rates get close or above the rates of longer term rates that we see an increased chance of slowdown and recessions.
In the chart above I have simply subtracted the interest rate on the 2 year US treasury bonds to the interest rate on 10 year treasury bonds. As you can see this running total fell this year to the lows of last year before starting to rebound. Rates are low but still far from inverting.