Most people think of bonds like Certificates of Deposit (CDs). You loan someone money, they give you interest each year, and then at the end of the contract you get back the full amount you initially lent. Over that time, your return should be whatever the interest rate was and if you think of it from a cash flow perspective, at any point during that period your return should also be that (positive) interest rate.

But in reality, bonds can lose value over shorter periods of time, even if they don’t default. Last fall, we published a piece discussing this phenomenon. At that time, we had many clients reaching out with well-founded concerns that their bonds were losing money. Since then, bonds have gone up in value as interest rates have fallen. We haven’t yet had any concerned clients asking why their bonds have made so much money in the last 12 months, but we figure calls will soon be coming (haha). As your favorite Syracuse based fee-only fiduciary advisor, we wanted to revisit the issue to help explain it again.

Let’s say an investor bought a $1,000 face value, five-year bond that paid 2.0% for $1,000 (par) when it was issued. A year later, the investor has received $20 in interest payments and now owns a four-year bond. But market conditions have changed, and new four-year bonds are being issued with a yield of 3%. If the investor wanted to sell the bond he or she bought last year, other investors wouldn’t pay full price for something that will give them 2% when they can get 3% out in the market. As a result, the original investor would have to sell his bond at a discount. In this case, the investor would probably only be able to get about $960 for this bond. This combined with the $20 in interest leaves the investor with $980 in proceeds on something that cost $1,000. This works out to a loss of 2%.

Over the last year the opposite has happened. Interest rates have fallen and the returns on bonds have exceeded their yield.

To complicate things further, most of our investors don’t own individual bonds, but rather bond funds. These funds own thousands of individual bonds and are constantly buying newer, longer dated bonds with the proceeds from maturing bonds. Through this process, the bond fund never matures and maintains a somewhat steady duration.

The most common fund our investors own is one which tracks the Bloomberg Barclays Aggregate Bond Market. The following table shows a first cut at how this fund has performed over the last year.

The decline in interest rates of 1.02% would lead to an estimated 6.12% increase in the mark to market value of the bonds it is holding. Over the last year it has also earned an estimated 2.58% in interest for a total return of 8.7%.

In reality, aggregate bond funds are up roughly 11%. The reason for the difference in this and the 8.7% we calculated above is two-fold.

  1. The majority of the decline in interest rates is from longer-dated bonds which appreciate more when rates fall. For example, a year ago the 1-month treasury yield was 2.11% and today it’s 2.05% – almost no change. However, the 10-year yield was 3.06% and today it’s 1.55% – essentially half of what it was a year ago! This different change in yields of different maturities has caused funds to appreciate more than you’d expect from their change in interest rates.
  2. The second and less impactful factor is that interest rates haven’t fallen in a straight line over the last 12 months. Interest rates peaked in November and still stayed relatively high until about May of this year. More time with higher interest rates means the interest earned over the last 12 months will be higher than our 2.71% estimate from the average.

The last 12 months has been great for bonds. Unfortunately, it’s nearly certain the next year, or five years, won’t be as good. Still, bonds add value to a portfolio by reducing volatility and earning a positive return over time. If you have any concerns regarding your bond holdings and how they impact your financial plan, please contact your advisor. It may be tempting to alter your investments based on future predictions of interest rates, but history has shown this to be difficult. Look for an article in our next newsletter documenting how poorly expert predictions were a year ago.

Stock Markets

Stocks rebounded nicely. Tech stocks (FANGs – Facebook, Amazon, Netflix, Google) after leading the way down in last year’s fourth quarter (off 22%) led stocks back up (up 23%). A global stock portfolio earned about 12% this quarter and domestic stocks continued in the forefront.

Looking past this quarter, non-domestic markets have fallen short of domestic market returns.  There is no reason to think this pattern will continue. Stock markets seemed to have calmed a bit, and some of the uncertainties that have plagued stocks in the recent past seem to be coming into sharper focus.  Trade negotiations with China are moving along in a more positive vein and stocks continue to respond nicely to positive news about any possible resolution.

Concerns of looming deficits due to tax cuts appear to have moved to the back burner as inflation and interest rates remain at historically low levels. Markets continue to shrug off any dysfunction in Washington.  Yet, concerns remain. How Brexit (Britain leaving the European Union) eventually plays out remains a mystery.

Bond Markets

Bonds, especially longer-term bonds, are up this month, which is consistent with declining yields, at longer maturities.  Look below to see how bond yields beyond a year are below last quarter and a year ago.  The ten-year yields are below one-month yields – the lowest is at the 5-year mark. This pattern is unusual. Perhaps the best explanation is as simple as this: in a world of low and negative interest rates, U.S. Treasuries are the “best deal in town” for safe assets.

Interest Rates

Interest rates are historically low and have confounded many observers – more than a few predictions have gone awry, and crafting a compelling story to explain why there is little difference between short-term and long-term rates remains elusive.  Additionally, by historical standards the Fed has massive levels of Treasuries and Mortgage-backed securities on its balance sheet, which it must deal with, creating even more uncertainty.

Interest rates are important to the economic landscape. They are the price of capital – interest is what must be paid to use someone else’s money. The Fed only controls short-term rates.  Longer-term rates are where supply and demand for capital intersect. Demand depends on the expected payoff for putting capital to work; supply depends on what you expect to earn for giving up the use of your money. The horizon for suppliers and users of capital is distant – slight changes in interest rate’s can have a significant effect.

Stock prices are the present value of all future cash flows, which theoretically go on forever.  Falling interest rates translates into rising values of these cash flows.  The historically low levels and generally downward trend in interest rates help to explain the long-running bull market.

Bond returns are affected by both absolute levels and changes in interest rates – rising rates produce lower bond prices and returns; falling interest rates work in the opposite direction.  The longer the maturity, the greater the impact of changing rates.  Declining yields at the long end mean better returns for longer-maturing bonds.

Where interest rates go from here is anybody’s guess.  However, right now there doesn’t seem to be much pushing rates up, especially with an expected slowdown in worldwide growth.  All indications are for rates to remain low with little difference between short and long rates for a while.

Jack Bogle

Jack Bogle, the godfather of index funds and founder of Vanguard, passed away in January at age 89.  His influence on the investment world over the past forty years is immense; his accolades are well-deserved. Jack Bogle’s unwavering commitment in his ideas alone set him apart.  While the underlying concepts behind index funds are now the mainstream, they surely weren’t when he first championed them.  Jack Bogle clearly did more than anyone for small investors.  The notion behind Index Funds (achieving market results at the lowest cost to have the best chance for long-term success) is equally applicable to all investors – both large and small.