The first thing that we learn in Fixed Income 101 is—when bond yields go up, bond prices go down—and vice versa. And since the U.S. presidential election, bond yields have gone up as the market has digested the potential implications of a Trump presidency. The market was clearly surprised by the outcome and has shifted gears to contemplate higher future inflation as a result of perceived aggressive fiscal policy coming out of Washington D.C.
This all makes perfect sense; if inflation is seen as being higher in the future, investors will demand more compensation to lend money via the bond market. Combine this with a Federal Reserve that is seen as more and more likely to raise interest rates this year, and—on the surface—it doesn’t paint a favorable backdrop for investing in fixed income.
But of course there is always more to the story. Once we’ve mastered Fixed Income 101 and moved on to Fixed Income 201, we learn all about the power of compounding interest. Simply put, higher rates result in lower bond prices, but more importantly higher rates also result in higher rates (This is more of a 301 concept!).
The implication for mutual fund investors is that their holdings will now earn a higher yield, leading to higher distributions. For investors reinvesting these distributions, they will be able to reinvest at higher yields allowing them to benefit from the virtuous cycle of compounding interest at the new higher rate.
What I just described is intuitive, but probably not top-of-mind when rates are rising and bond returns are depressed. It’s a classic case of enduring short-term pain for long-term gain. In fact, long-term investors in bonds should welcome higher rates. As a rule of thumb, investors with a time horizon longer than the duration of their bond holdings may be better off in the long-term with a rise in rates today.
The mantra of discipline and long-term investing is never more important than when market volatility jumps. Volatility is more commonly associated with stocks rather than the sleepy bond market, but the same principles apply. And given the interplay of price and yield, it’s compelling to continue to invest in fixed income and rebalance to long-term asset allocations when rates are rising. One thing we can be sure of is that the market will continue to interpret and adjust to what the economy will look like over the next four years and beyond, and there will be bouts of indigestion as new information is introduced.
When it comes to navigating uncertain times, stick with your game plan, ignore the noise, and remember the long-term outcomes—courtesy of Fixed Income 201.
- All investing is subject to risk, including the possible loss of the money you invest.
- There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
- Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.