The Bond Market Bubble Move
Bonds are kind of a funny thing for people to wrap their minds around. I can relate because it was initially a challenge for me when I tried to wrap my finite mind around it. The fact is, bonds are ultimately a loan to the government or a company which gets paid back to you with an interest payment. That’s what most people’s understanding of bonds consist of, which is just basic.
Many people purchase bonds and are fine with the fixed returns on what they are getting regardless of whether rates go up or down. So long as the entity paying for the bonds does not fold, your payment is secured and fixed. This is not an entirely bad way to go about bond investing, but it gets a bit more complicated when you want to buy and sell them.
Let’s delve into this a bit more…
Bond interest rates are fixed, so if interest rates go up, the cost of the lower paying bond must go down to be marketable. The same is true if bond interest rates go up, higher yielding bonds will cost more. Picture a seesaw with interest rates on one side and bond prices on the other. Think about it, no one in their right mind is going to buy a similar bond yielding a lower rate for the same price as one with a higher yielding payment.
Right now, we are literally at the end of what has been a three decade long bull run in the bond market. In the past 30 years or so, bond yields have declined so much that returns are hardly high enough to beat inflation.
This of course is on top of the fact that the Fed is manipulating the market so much that each time they purchase bonds to keep rates low, they drive bond prices artificially high.
Long-term interest rates are still near their recent lows and have only climbed marginally. Long term bonds are what will collapse the most as interest rates continue to rise.
One of the places to be, in turn, is in the short-term high yielding bond market. These bonds too will see a hit in their prices, but will be much lower than long-term positions of 10-30 years.
Short-term bonds generally have shorter durations and are less sensitive to movements in interest rates than longer-term bonds. You can buy bonds that mature in a few days or in 30 years. If rates rise, the interest rates on bonds with a longer maturity are locked in at a lower rate for a longer period of time. If a fund has a duration of three years, for instance, it will decline 3% if interest rates rise one full point. If the duration is two years, it will decline 2%.
This of course is an obvious hit in your portfolio, but it’s minimal compared to having all of your money in long-term bonds that will literally collapse over the coming years. It’s obviously not wise to run from all risk, what is characteristic of a sound investor is the ability to manage it as best as possible.
Additionally, high-yield bonds may also experience some price support if the business that issues the bonds grows stronger. Rising rates have often accompanied an improving economy. Those economic improvements may benefit the issuer of the bonds, and that can lead to better performance for the bonds, helping to offset the damage from rising rates.
This is definitely some food for thought for those learning and in the bond market currently!
Best Wishes In Trading,
Editor at CrushTheStret.com