Fixed income pundits have called for an end to this bull market run for several years now, but it hasn’t happened yet (at least not as of this writing). Interest rates today may be higher than they were at their lowest point of last year, but they really haven’t broken out to the upside as of yet. Certainly not enough to say the decades-long bond bull market is over.
But at some point, this run is going to stop and there will be a trend shift toward sustained rising interest rates. That’s why we believe the risks for bond investors are as high as ever in the current market environment. Many people see their bond holdings as conservative investments, but this mindset needs to change with bond market risks at their highest levels.
How did we get to this point? Let’s explore this question by looking at the role the Federal Reserve has played in lowering interest rates and raising risks for bond investors.
The Fed also rises
Many people, both inside and outside the government, recognized the need for greater stability in the U.S. financial system. Congress responded by passing the Federal Reserve Act, which was signed by President Woodrow Wilson in 1913. The law laid the groundwork for the establishment of the Federal Reserve System.
The Fed was created as a decentralized central bank in a compromise between the interests of powerful financial institutions and the needs of the general public for a solid and strong U.S. banking system. In its early years, the Federal Reserve worked to dampen volatility in the U.S. economy, especially during the Great Depression. Its mandate expanded to include open market operations and examinations of bank holding companies.
The Federal Reserve as we know it today would emerge in the early 1950s because of an agreement between the Fed and the U.S. Treasury related to interest rate pegs on government bonds. The federal government had borrowed significantly to finance the costs of World War II and the Korean War. Treasury officials wanted the Fed to keep interest rates low to support the war efforts, but central bankers were wary of the inflationary effects that “easy money” through unnaturally low interest rates could have on the U.S. economy.
The Treasury Accord, as it came to be known, gave the Fed more independence and entrusted the central bank with the ability to use the Fed funds rate as its monetary policy tool to guide the U.S. financial system.
The Fed flexes its power
Volcker’s moves weren’t popular—his “tough love” approach to monetary policy raised borrowing costs for businesses, homeowners and the federal government in addition to contributing to the recession in the early 1980s. Ultimately, Volcker’s Fed won the battle: tighter monetary policy loosened the inflationary chokehold on the U.S. economy despite the short-term pain of higher interest rates. Inflation dropped from a peak of over 13% in 1979 to around 3% by 1983.
What does this mean for conservative investors?
Astute investors are aware of the inverse relationship between interest rates and bond prices (i.e., rising rates decrease bond prices, and vice versa.) However, the math behind this relationship can be elusive. Investors need to understand how this dynamic affects the risk of bond investments.
Let’s take a simple example of a 30-year bond that has a $1,000 par value and a 7% coupon. As illustrated below, nominal interest rate increases of one and two percentage points can have drastic effects on the price of this bond. Declines of over 10% and 20% don’t seem very conservative.
How can Potomac help?
As a tactical investment manager, we have a handful of strategies for conservative investors to help minimize the risk of rising interest rates and falling bond values.
One of those strategies is our High Yield Plus program, which focuses on the tactical trading of high yield bonds. High yield bonds are often misunderstood by the general investing public, but when used properly they can complement nearly any investment strategy.
Historically, high yield bonds have demonstrated positive returns in rising rate environments. And by working with a tactical investment manager like Potomac, investors have access to a strategy that can help protect their assets in rising rate environment.