Why Bonds Are Getting More Attention — and Why They Should

Part One of a Three Part Series

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Bonds typically take a back seat to stocks with the pundits, prognosticators, and most investors. No surprise. Stocks are more exciting, and for the most part simpler to understand. Lately, though, conversations and commentary around bonds have shared the spotlight with speculation about future stock returns.

The catalyst for the growing interest in bonds is the unique set of circumstances we currently see in the market. The fed funds rate, a key benchmark interest rate, has been at near zero for seven consecutive years; however, the Federal Reserve has been making its intentions clear with a more hawkish (optimistic) path of future rate hikes. More recently, the 10-year Treasury, a closely watched benchmark, rose to 3% for the first time since 2014.

Graph illustrating the positive relationship between longer term to maturity and bond yield.
FIGURE 1: U.S. Treasury Yield Curve as of 3/31/18

The prospect of rising rates has material implications for both the economy and investors, pulling bonds into the center of investment discussions. That's why this quarter we're focusing our commentary on bonds, in lieu of a recap of the market during 1Q 2018. Over a series of three pieces, we hope to share some insight about bonds—how they react to various market forces, how the Federal Reserve's decisions affect bond yields, and how investors should be thinking about the role of bonds (fixed income) in their portfolios. In this piece we review two key fixed income components, yield and price, and the important relationship between the two.

Bonds are different from stocks because there is a known stream of interest payments, and the ending par value that is returned at maturity. Typically, bonds with longer maturities offer a higher yield to offset the risk of foregoing repayment for a longer period of time. This relationship is commonly expressed in a yield curve which shows at a point in time, what rate the market is willing to pay for bonds of various maturities. The most popular yield curve is for U.S. Treasuries as it serves as a benchmark for other bonds, and reflects the markets expectations for future rates, inflation, and economic growth. Figure 1 represents the Yield Curve as of 3/31/18.

The yield curve gives us a starting point to explain dynamics that affect the pricing of all bonds, the impact of rising and falling rates, and the reason the decisions by the Federal Reserve matter so much.

How are rates for different bonds determined?

Bonds are issued by a wide variety of entities such as corporations, municipalities, and non-profit organizations. Each of these entities introduces additional risks that affect the interest rate, or yield, an investor expects to be paid to buy the bond.

Arriving at the yield for any given bond can be thought of as an additive process that begins with a risk-free rate (U.S. Treasury rate). The rate is then increased for specific risks assumed by the investor such as credit, liquidity, and/or call and extension risk. The resulting yield for a 10-year corporate bond, for example, might look something like this: 10-year Treasury yield (currently 3.0%) + 0.5% for company-specific credit risk + 0.5% for liquidity risk + arriving at 4.0%, or 1% of additional yield ("spread") above the risk-free U.S. Treasury with the same maturity. The concept of "spread" is a common expression of the extra yield expected from a particular issuer based on the perceived risk for a given bond.

Why do bond returns vary from the stated interest rate?

Even though bonds have a known stream of payments, a bond's total return is still comprised of two components, yield or the interest payments you receive, as well as changes in the bond's price. If the payments are known and fixed, you might be asking yourself, what is it that would affect a bond's price?

Graph illustrating the positive relationship between longer term to maturity and bond yield.
FIGURE 2: The impact of changes in yield on bond prices.

As shown in the chart above, there is a relatively simple principle that governs the relationship between fixed income yields and prices. When yields rise, prices fall, and vice versa. Think about the individual yields at each point in time as our required return for investing that cash flow. What price would you be willing to pay to receive $100 one year from today? If we see from the yield curve that a one-year bond with similar risk as our $100 payment is yielding 2% today, we can calculate the present value of this cash flow using the market yield as our required return: $100 / (1+0.02) = $98. With a required return of 2%, we would pay $98 for this cash flow, but this is using the prevailing market return. What if our required return was 3%? A 3% required return would increase our denominator and lower our price to $97, would we still be willing to buy this cash flow at the current market price? Probably not.

All bonds are priced using the same principle as our single cash flow example by aggregating the present value of all the known cash flows into a single price. Therefore, as market yields rise, the denominator in our present value calculation (our required return on our investment) also rises (holding credit and convexity stable), and the market price falls. The opposite occurs as market yields drop. Because the return required by investors is now lower than what is being paid by bonds available in the market, the market price increases.

So, how does the Federal Reserve's decisions affect rates?

The Federal Reserve does not directly set bond yields, market forces do. However, the Federal Reserve sets the fed funds rate (the rate at which credit-worthy banks lend to each other overnight), which serves as a foundation for short-term, risk-free interest rates. Therefore, increases in the fed funds rate often lead to increases in short-term treasury yields.

Recall that other bond yields are benchmarked against the treasury yield curve, so an increase in short-term treasury rates raises the short-term required return for other issues as well. Further, we know that when the required return (yield) increases, prices fall. So, decisions and forecasts by the Federal Reserve about raising rates do have an impact on bond prices and bond returns.

Market yields are dynamic and complex, and forces affecting short-term yields are often different from those impacting longer-term yields. Armed with a better understanding of bond yields and their impact on bond prices, our next piece will introduce interest-rate risk, the risk that an investment's price will change based on a change in interest rates, and common tools to measure and manage this risk.

Matt Heimann, CFA
Portfolio Manager

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