- Rising interest rates have brought unfamiliar volatility to bond prices while also raising yields.
- Higher yields mean bonds can now play a more significant role in income investing strategies than they have since the global financial crisis.
- Increased volatility may create opportunities to buy higher-yielding, lower-risk bonds at attractive prices.
- Professional investment managers have the research, resources, and investment expertise necessary to identify opportunities and help manage the risks associated with bond investing in a rising rate environment.
In diversified portfolios, bonds have long played the role of steady, reliable older brother to stocks’ impetuous little brother. Where stocks have been venturesome, bonds have been cautious, giving investors lower returns but also less volatility.
But over the past year, bonds have taken to behaving more like stocks. Indeed, from October 2021 to October 2022, the price of the Bloomberg Barclay’s US Aggregate Bond Index, which represents the vast investible universe of US bonds, has dropped almost 16%, essentially equaling the decline of the S&P 500 over the same time.
While history says that investors should expect this sort of behavior from the S&P once every 5 years or so, this is not typical for bonds. This year, in fact, bond prices are on track to post a second consecutive year of negative returns, something they’ve never done before.
Despite this, bonds are resembling stocks in a good way too. For the first time in decades, bonds yields are similar to what income-seeking investors might expect from stocks. As of October 28, 2022, shorter-term Treasurys are yielding more than 4%, investment-grade corporate bonds around 6%, and high-yield corporate bonds close to 9%. These yields compare favorably with a total return of the S&P so far this year of −17%.
Why this is happening
So why are bonds suddenly acting like stocks? Director of Global Macro Jurrien Timmer says the Federal Reserve is enabling the bond markets’ stock-like volatile behavior. Bond prices typically fall when interest rates rise so bond markets have long been sensitive to changes in rates by central banks. Since the global financial crisis, though, the interest rate and asset purchase policies of the Fed and other central banks have become by far the most important forces acting upon the world’s bond markets. Now, the focus of their policies is changing from supporting markets to fighting inflation and stock and bond markets alike are both reacting.
So far, the Fed’s moves to raise rates have ended the bull market in bond prices that had been running since 1982. Higher interest rates typically mean lower bond prices and many investors have been selling bonds based on their fear that higher interest rates will cause bond prices to fall. That fear has become widespread enough that bond prices have suffered right along with stock prices, which historically have often fallen when rates have risen.
But while higher interest rates have pummeled bond and stock prices alike, bonds still differ from most stocks in that they pay interest and that fact is especially meaningful in a time of rising rates. Because higher interest rates mean higher bond yields, investors’ angst about how rates affect bond prices shouldn’t obscure the fact that the return of rates to historically normal levels may present a long-awaited opportunity in bonds for those who seek income and principal protection. As Managing Director of Asset Allocation Research Lisa Emsbo-Mattingly puts it, “The Fed had been financially repressing savers, especially retirees.” Now, though, rising rates mean that retirees and savers may once again be able to earn attractive returns without taking much risk.
The price is nice
Not only are yields up, prices are down, which is offering opportunities for those with cash to invest. Investor anxiety is creating opportunities to buy relatively low-risk assets at bargain prices even as they pay yields that are higher than they have been in decades. Fears about higher rates are having more impact on bond prices than are fundamental factors that might otherwise cause investors to seek bonds. That obsession with the risks posed by rising rates may be causing investors to sell bonds without regard for the attractive coupon payments that can help retirees and other investors to meet their needs for income.
How long will this go on?
Emsbo-Mattingly expects the Fed to continue to raise the federal funds rate further until it has an impact on inflation. If inflation comes down closer to the 2.5% range where the Fed wants it, real rates, which are bond yields minus the rate of inflation, could rise further into positive territory. This would help high-quality bonds to once again be meaningful contributors for many retirees who are looking to supplement Social Security, pensions, and other sources of income.
This opportunity could be short-lived. Getting inflation under control is the focus of Fed policy in the months ahead, but the central bank also wants to make sure it has room to cut rates when the economy goes into recession, potentially in 2023. Rate cuts are the most powerful tools the Fed has to stimulate economic growth and the central bank wants to be able to make impactful cuts when necessary. That could mean that the opportunity to add low-risk bond ladders to your income strategy may not be there if you wait too long.
If you’re interested in adding bonds to your portfolio, you can choose from individual bonds, bond mutual funds, and exchange-traded funds as well as other bond-like fixed income products such as CDs.
Funds and ETFs offer exposure to the ups and downs of markets where prices change on a daily basis. When interest rates rise, bond fund and ETF prices tend to fall. But when interest rates begin to fall and bond prices rise, bond fund and ETF holders have the potential to benefit.
For retirees and other income seekers who are willing to hold individual bonds to maturity, rising rates can be a good thing. For the first time in decades, it’s now possible to generate a reliable flow of income by arranging low-risk, high-quality bonds or CDs of varying maturities in a ladder.
If you're considering individual bonds, you should know that the bond market is large and diverse and getting the best prices can be tricky. Fidelity can help by offering a wide range of ways to research bonds as well as professional help to construct a portfolio that reflects your needs, your tolerance for risk, and your time horizons.