Year over year inflation was 10.32%. The Federal Reserve hiked interest rates to over 19%. A 3-month CD was yielding 18.3%, and mortgage rates topped 16%. The year was 1981.
Fast forward 42 years. Year over year inflation in the US has topped 8% as of March 2022. Will it reach 1981 levels? Who knows for certain, but this is the highest rate of inflation we’ve experienced in four decades. Though it is well below 10.32%, the rapid rise after a decade of sub 2% inflation seems shocking to many folks.
In the attempt to curb inflation, the Federal Reserve has announced aggressive action. They have announced a series of interest rate hikes that are anticipated to raise the overnight lending rate between banks to 2% or more in the next 24 months.
While the Federal Reserve doesn’t directly control treasury or corporate bonds yields, their actions do signal an expectation of rising interest rates throughout the economy, and interest rates have been on the rise since hitting a low point in 2020.
As an example, the 10-year treasury yield dipped below 0.60% in July of 2020. Since then, this benchmark interest rate has been on an accelerated pace. As of April of 2022, it clipped 2.72%, which is an increase of 361% in less than 2 years.
Corporate bond yields have risen from about 2% to over 3.75% during the same period. What happens to treasury and bond prices when interest rates rise? That would be a worthy question to ask.
The rapid rise of interest rates has put downward pressure on bond prices, turning what once was perceived as safe investment into a volatile loser.
Aren’t Bonds a Safe Hedge Against Stock Market Risk?
For decades investors and their advisors have relied on modern portfolio theory to manage risk versus return. A well-balanced portfolio of stocks and bonds seems to have proven successful for nearly half a century. Fixed income, or bonds, were used to offset risk in equities, or stocks. When stocks were selling off, bonds were up. When bonds were losing value, increases in stock prices seemed to balance things out.
There has been a perceived correlation between stocks and bonds. Many investors might be able to point this out when prompted, or at least acknowledge having been told this by someone they perceive as an expert. It seems almost common knowledge that when stock prices fall, bond prices rise because of an inverse correlation to one another. However, does such correlation exist?
Interest rates have been falling since the early 80s. Over four decades interest rates continued a steady decline until reaching a low point shortly after the pandemic. Most financial advisors practicing today have only been exposed to this environment, declining interest rates and rising fixed income prices.
Very few, unless they’re in their late 60s, have ever advised anyone through a period of extraordinary stock market volatility, and rising rates. If they have, they were most likely advising a younger investor, not someone transitioning into or already in retirement.
Many of the tools and strategies that financial advisors have relied on for decades may not work so well during a period of rising interest rates. Some advisers have unfortunately ignored tools that will likely help folks deal with this new environment.
You’ve probably been told that you should own stocks for growth, and bonds to offset market risk. A good portfolio is made up of the correct ratio of stocks and bonds based on your age and risk tolerance. This has been the status quo for investment management for decades.
Does an Inverse Correlation Between Stocks and Bonds Exist?
Fixed income, or bonds, have proven to be a good hedge against stock market volatility over the past 40 years. Should we not expect this to continue? In fact, many folks believe that there is an inverse-correlation between stock market movement and bond prices. However, it may not be true at all. Could it be a false belief based on observations of causality somewhere else in the economy that may not be directly correlated to the stock market?
Here’s why we say this. Stock market volatility often produces a flight to quality. That flight to quality often results in investor shifting risk assets to low-risk assets like fixed income (bonds) or cash positions.
When there’s a flight to quality, there’s a high demand for these instruments. That high demand puts a downward pressure on current yields. In other words, the issuers of debt instruments, say corporations selling their bonds, don’t have to pay the lender (investor) as much when there’s a high demand for their debt. When this happens, yields are forced down across lower risk assets. As yields fall previously issued debt, higher yielding bonds that have already been issued for example, rise in value.
If I own a bond yielding 4%, and interest rates fall due you to a flight to quality, and issuers of similar quality and duration are only offering 3%, the value of my bond increases. It has become more valuable to those wishing to purchase fixed income.
As interest rates fell over four decades, they created a pattern of price appreciation on previously issued fixed income. Market sells off, there’s a flight to quality, bond yields decrease, and bond prices rise. Wash, rinse, and repeat. Giving the perception that there’s an inverse relationship between stocks and bonds.
However, stock market volatility was only the catalyst to shift attention towards an asset class with a lower perceived risk. The stock market itself didn’t make fixed income assets rise, it was the demand for fixed income resulting from stock market volatility that pushed yields lower and made fixed income prices rise.
Today we are in a situation where fixed income yields are near historic lows. It is less likely for interest rates to continue to fall, and thus create subsequent price appreciation. It is more likely that interest rates will rise resulting in subsequent price depreciation.
What you end up with is very low yielding assets with the extreme likelihood that those prices will fall as interest rates rise. This produces a very poor risk return profile in our opinion. One that most advisors have little experience with. One that doesn’t fit neatly into their legacy investment management strategies.
How Do Rising Yields Impact Bond Prices?
So, what happens to these lower-risk investments when interest rates rise, and how does that impact your portfolio?
Let’s say I own a 3% yielding bond with a duration of 10 years issued by company XYZ. One year later interest rates have risen. An investor seeking to purchase fixed income for his portfolio could find a bond of similar duration and quality that is yielding 4%. Why would he want to buy mine when it is only yielding 3%? The answer is that he wouldn’t.
Let’s assume that I originally purchased the bond in my portfolio so that I could offset stock market risk and create liquidity to maintain my lifestyle during a stock market sell off, similar to what’s happened at the beginning of 2022. Inflation concerns and the threat of rising interest rates has triggered a stock market pullback. Equity positions have lost 10 to 15% of their value since reaching highs near the end of 2021.
If I need to liquidate investments to free up cash to maintain my lifestyle, I might consider selling my fixed income assets like my bond yielding 3%. After all, they were purchased to offset market risk.
However, the interest rate environment has changed quite a bit in the past 12 months. Those desiring to purchase fixed income could earn a much higher yield (4% in our example). I will likely end up having to sell my investment at a discount creating a capital loss. How much of a loss?
That 1% rise in interest rates may cost me about an 7.7% if I sold my investment. Fixed income and equities have both lost value under these conditions and I am stuck between a rock and a hard place. That is unless I have liquidity in a place not subject to stock market and bond market risk. Besides cash positions, does such financial instrument exist? The answer is yes.
An Alternative to Fixed Income
Financial instruments do exist today that can effectively manage stock market volatility, and bond market price risks as interest rates rise. At the same time, they can often provide the potential for a return that is quite competitive with current yields on fixed income assets like bonds. These instruments use income from lower risk investments to purchase a hedge against future stock market growth. Some of these instruments are packaged by insurance companies, other by banks, and a few are manufactured by boutique investment firms for individual investors.
Nevertheless, they share similar objectives:
- Mitigate market losses
- Link future accumulation to the movement of an index (Example: the positive market movement of a major market index like the S&P 500).
- Limit exposure to interest rate risk – the major risk with owning bonds in a rising interest rate environment
Most advisors today have never guided folks to and through retirement during a period of rising interest rates and stock market volatility. It’s likely they have only dealt with the stock market volatility during a period of falling interest rates. The financial instruments and strategies that seemed tried and true for decades may no longer be as affective during a period of stock market volatility and rising interest rates. Clutching onto tried-and-true strategies of the past may no longer serve the best interest of investors seeking to maintain a consistent standard of living throughout their retirement years.
It may be time for a different approach to investment management. One that includes strategies that mitigate both stock and bond market losses while providing better than average opportunity to earn a rate of interest that is competitive with current fixed income assets.