Are bonds safe?
Written by: Benjamin Bimson CIMA® / BCJ Financial Group
“Bonds are safe.” Or so we have been told. Is it true?
Seemingly overnight, expectations for a March rate hike by the Fed have become so strong that the markets are nearly unanimous that the Fed will raise interest rates at the March 15 meeting. This stuff gives encouragement to keep geeking out in order to understand the “what and why.”
I want to start off giving you a big picture. Here is a chart of the 10 year treasury rates going all the way back to the beginning of the 1970s.
Yields in Treasury bonds have dropped down to an all-time low. The backdrop for the past 10 years seems to be closing out. Thankfully it doesn’t look like it will be slamming shut in our face, but rates are climbing.
The rates inching higher, re-accelerated, this last week after economic data released approaches the Fed targets and a slew of Fed member speeches. Janet Yellen, in a Friday speech in Chicago indicated that further adjustment of the federal funds rate would likely be appropriate. The following shows the probability, which began the week at roughly 33% for a March rate hike, then jumped to 86.7%. Here is what it now looks like on the projections (as of Friday AM 3/3).
As rates rise, pressure on price brings bond prices downward. This can be seen on a chart below which plots the difference between the price of Intermediate Term Corporate bonds in the ETF CIU and the 7-10 year Treasury ETF IEF.
Using multiple moving averages, it is easy to see where price movements have been negative based on interest rate moves. I highlighted the biggest three from the past 10 years (red sections). The first occurred after the initial crisis when investors began investing back in stock in 2009. Treasuries went down 5.8% in the 12 months following the market lows in early 2009. The next happened in 2013 and resulted in 10 year Treasuries falling 6.68%. The most recent began last July. It is down about 6.79% so far. Here is what the chart looks like with annotations to make it easier to see.
So, where from here? Well, if the Fed raises rates in March, June and December, Treasury rates are likely to continue this downward cycle. If we are in a longer rate hike environment, reflating the rates and the Fed does it without attracting too many foreign purchasers of US Treasuries, it could last for some time. That does not mean all bonds will suffer equally.
Corporate bonds are often issued at higher rates and as long as they are better than dividend rates, investors seeking income will keep holding and purchasing them. A longer-term rate increase environment would indicate lower expected returns in all bonds however because typically the Fed enters long-term rate hike campaigns when the economy is robustly moving forward and that is normally a good environment for stocks. There is a lot that can be conjectured, but so much of what will happen is about how all the puzzle pieces end up fitting together.
Our recommendation is that you make sure you understand the unique risks bonds pose today. Since 1981, bonds have been in a decreasing interest rate move and have seemed exquisitely safe. That looks to be changing. Tides are turning and rates might be about to lift off. Hopefully this Fed can raise rates and balance all the balls in the air. Every investment option is subject to unique risks and now is a good time to understand what risks bonds present.
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