What's Up with Bonds? They're Down!

Bonds play an important role in diversifying your portfolio. They typically have lower volatility, thereby dampening your downside risk. (Remember March of last year?) By acting as a ballast when the market drops, bonds allow us to hold on to our stocks as well as provide liquidity if we need to raise cash.

 Bonds can, however, lose their value on occasion. The Bloomberg Barclays Aggregate Bond Index was down 3.4% in the first quarter of this year. How did this happen? Blame rising interest rates.

At its most basic, let's say you own a bond that pays 2%. Later on, interest rates rise and you can purchase a comparable bond paying 2.5%. Your 2% bond now looks less attractive, so its price declines to make its yield competitive with its peers. (As its price declines, its yield rises.)

The details of how this works can be found by clicking this link. You can also contact me; I'm happy to discuss this with you in more detail.

Of course, diversification has worked well within the bond universe. Short-term bonds, for example, have held up much better than the above-cited index as they are less sensitive to changes in interest rates.

What's driving interest rates higher? The anticipation that inflation will grow. The reasons for concern include:

  • The Federal Reserve appears willing to allow inflation to rise in order to get the economy moving again 
  • Fiscal stimulus, such as the $1.9 trillion relief package, has pumped a significant amount of money into the economy
  • Pent up demand to spend money may be unleashed as the country begins to open up; people (in the aggregate) have been saving a lot of money due to the restrictions implemented to battle the pandemic

On the other hand, there are reasons to believe that inflation may stay relatively muted:

  • Despite vaccinations, Covid-19 may be harder to eradicate than we had hoped
  • The economy may not keep up its strong pace of recovery
  • There may be sufficient slack in the economy to absorb the current economic growth
  • Full employment may remain elusive for a while
  • The move towards greater automation and digitalization helps to keep prices of goods and services lower
  • The demographic trend of an aging population can be a drag on growth as older people tend to spend less than their younger counterparts

Beyond the debate on inflation, the yield on U.S. bonds may be constrained by the fact that they tend to have higher rates than similar foreign bonds, making U.S. bonds more attractive. This increases the demand for U.S. bonds, which keeps their yields in check.

Words of Wisdom

I have never been lost, but I will admit to being confused for several weeks.
-- Daniel Boone