Given the apparent end of the multi-trillion dollar government stimulus known as Quantitative Tapering (QT), interest rates have started to rise.
In fact, the yield on the 10-year US Treasury rose from 1.52% at the end of last year to 1.92%, an increase of 26.32%. With this in mind, we thought it appropriate to illustrate the impact this will most likely have on your bond portfolio.
Generally speaking, bonds are negotiable securities that can be bought and sold after their date of issue and before their date of maturity. With this in mind, the first fact that any investor in these fixed income securities should realize is that the price or value of a bond will react inversely to interest rates. As interest rates rise as they have so far this year, bond values decline.
Conversely, if the recent rise reverses and rates fall, bond values will rise.
As an example, suppose that on December 31, 2021, you invested $100,000 in a ten-year U.S. Treasury bond (both principal and interest payment guaranteed by the full faith and credit of the U.S. government widely accepted as the safest fixed income investments in the world). As detailed above, the going rate that day was around 1.52%, which meant that that $100,000 would earn $1,520 in interest, or $760 paid semi-annually, every year for ten years. . However, since then the yield has climbed to 1.92%.
Therefore, if you buy a bond now, you will receive annual interest payments of $1,920, paid semi-annually. Following the rise in interest rates, what happened to the interest payments and the value of the 1.52% note you purchased on December 31? Very briefly, the interest payments of $760 semi-annually will remain the same for the remainder of the life of the note or until it matures. However, the principal value of the bond, if you want to sell it before its maturity, has gone down. After all, who would give you $100,000 for a bond yielding 1.52% when they could now buy their own bond yielding 1.92%?
The answer, sensible person. You’re stuck receiving $1,520 per year for the rest of the life of the note rather than the $1,920 you would receive if you had waited for interest rates to rise a bit. The loss to you is $400 per year for the remainder of the term or nearly $4,000 in total income.
You can therefore conclude that your bond or your bond fund may fall in price or in net asset value. As there has been a mostly unbroken bull market in bonds for nearly forty years, it is important to reaffirm that bond prices react inversely to interest rates. When interest rates rise, bond values fall and when interest rates fall, bond values rise. With interest rates still near 50-year lows, the most likely direction for interest rates is up.
What should an investor do now? Be patient. Let’s see how the economy reacts to all this quantitative tightening. Let’s see how President Biden and his administration handle Congress, the economy, tax reform, the burgeoning deficit, trade, foreign policy, and geopolitical events.
Keep in mind that two of our main principles of investing are 1) asset allocation works best over the long term and 2) investing in bonds for income and stocks for growth. Try to stick to the middle part of the yield curve or bonds that mature between four and eight years. By doing so, you will receive more than half the interest of a thirty-year bond with much less principal risk if you wish to sell your bonds before maturity.
Please note that all data is for general information purposes only and does not constitute specific recommendations. The opinions of the authors do not constitute a recommendation to buy or sell the stocks, the bond market or any security contained therein. Securities involve risk and fluctuations in principal will occur. Please research any investment thoroughly before committing any money or consult your financial advisor. Please note that Fagan Associates, Inc. or related persons buy or sell securities for themselves which they also recommend to their clients. Consult your financial advisor before making any changes to your portfolio. To contact Fagan Associates, please call (518) 279-1044.
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