Bond Prices

Sam Ngooi Comments

As stock price volatility continues, both up and down (more down for September and October, after a major gain from the 2020 lows in March through August), investors tend to pay more attention to bonds as an alternative to stocks for their liquid investment portfolios. (Although our Comments are written as of the end of each month, we take note of a major gain in stock prices during the first week in November, coinciding with the election. Further discussion of the recent election follows.)

Three primary factors that impact bond prices are: (1) changing interest rates; (2) maturities; and (3) credit quality.

Changing Interest Rates: As bond prices for already-issued and still-outstanding bonds fluctuate in the marketplace (based on changing interest rates for newly issued bonds of similar maturity and credit quality), the interest earned on these outstanding bonds changes as well (expressed as “yield to maturity (YTM).” Buyers of bonds will earn the currently-quoted YTM if the bonds are held to their maturity. For example, the owner/seller of a bond bought three years ago with a ten-year maturity and 3% annual interest payment (referred to as a “coupon”) should receive a much higher price from a current buyer than that same buyer would pay for a bond with seven years to mature and a current YTM of less than 1%. The higher price is determined by calculating all the coupon payments to be received, and then adding the higher payment the buyer had to make compared to the maturity value. This explains why a decline in interest rates leads to higher bond prices, and conversely, higher interest rates lead to lower bond prices.

Maturities: Short-term (overnight) rates are set by the Federal Reserve; as maturities lengthen, the buying and selling of bonds by investors and traders establish interest rates and bond prices. Normally the short rate set by the Fed establishes a guideline for what longer maturity bond prices should be. At the beginning of 2020, the US Treasury ten-year bond had a YTM of 1.92%, and the much shorter three-month US Treasury had a YTM of 1.55%.   This spread of 37 basis points (“bps”, or hundredths of a percent) between the ten-year and three-month was itself unusual, because a ten-year bond has significantly more price risk than a three-month bond, and typically will have two percent or more yield spread to compensate the owner for additional price risk. The reason longer maturities have more price risk is that if rates go up and the bond owners hold ten-year maturities, they will have to wait ten years collecting lower coupons. If the maturity is one year, on the other hand, bond owners will receive their money back in one year, with the opportunity to reinvest sooner at the higher rates.

Credit Risk: This concept refers to the likelihood that the issuer of the bond will repay interest as scheduled and the principal of the loan at maturity. Bond issuers include the US government (which sell “Treasuries”), state and local governments (which sell municipal, or “muni” bonds”), and corporations. During February and March 2020, when the extremely negative economic effects of the coronavirus first became apparent, credit risk increased for many bonds, even previously creditworthy ones. The prices of existing bonds declined as interest rates increased, since bond buyers demanded more interest for lending their money to issuers. The Federal Reserve and Congress then made significant amounts of money available to help support the economy. Since that assistance/intervention, the YTM on the ten-year Treasury has declined to around 60 bps, and the YTM on the three-month Treasury has fallen to about 10 bps. The yield spread has widened to 50 bps from the 37 bps at the start of 2020, but the absolute amount of interest being paid has fallen to historic lows (recall that for YTMs to fall this low, bond prices must rise, so bond buyers would only receive the YTMs if the bonds are held to maturity).

Higher credit risk bonds (i.e., “junk bonds”) are issued by borrowers who are less likely to pay interest or principal, and therefore have to offer higher rates to induce investors to buy the bonds. While the higher coupons may seem appealing, they should be approached with caution, because the higher risk of default is real, and is the rationale for the higher initial coupon. The yield spread at any time between high credit bonds and junk bonds provides a current market assessment of the greater risks involved with low credit quality bonds.

PPA Comments: The idea of buying bonds with ten-year maturities that pay less than 1% interest each year provides an indication of just how little investment return is available currently from high-credit quality bonds.  The declining price risk arises when and if the economy improves enough for interest rates to begin to rise, in which case bond prices fall to give the buyers the then-quoted higher YTM. For some time period, the declining prices due to rising rates are likely to overcome the higher interest being paid, but this impact also passes over time, as prices stop declining and rates and yields stop increasing. Of course, the length of time of this cycle of rising rates and falling prices is always an unknown before the fact.

Further, low interest rates typically act as a stimulant to the economy. These very low rates have made it easier for all bond issuers to borrow and, particularly in the case of US and state and local governments, the low rates have allowed for more borrowing with less concern for harmful inflation, at least in the short term until steady signs appear of an economic recovery from the coronavirus.

As has been mentioned in many recent Comments, low interest rates provide little investment return to investors, especially when the associated price increases have ended. This perhaps encourages investors (and traders as well) to be more likely to buy stocks, with a greater opportunity for gain (and of course, decline).

A recent New York Times article discussing bonds (NYT 10/11/20, page BU11), puts the current situation this way: “Owning US Treasuries, the undisputed safest bond, means signing on for next to nothing in earnings for the next five to ten years, because the current yield (our note: YTM) of a bond is a solid estimate of future annual returns, and Treasuries that mature in ten years or less currently have yields below one percent… While the historical long term average annual return for intermediate-term Treasuries is 4.5%, based on current yields, a return below 2% is more likely… And that’s before factoring in inflation, running currently at 1.3%.” The balance of the article discusses allocations to bonds and other liquid asset classes.

 

Political Uncertainty/ Election Results: Even though the election in favor of Joe Biden and Kamala Harris would appear to be over, President Trump has mounted legal challenges and has not conceded. That said, even assuming the Biden/Harris victory, we continue to repeat the essence of our recent Comments: the presidency is only one of many factors affecting stock and bond prices. Even if we know who is going to be president, no one can predict what will happen during that presidency. Trump’s presidency is a perfect example (see July Comments). There is nothing inherently predictive about the connection between market prices and election results, certainly not as time passes and other intervening events become more important.

Our advice remains the same: maintain asset allocations developed for your circumstances for the long-term, and rebalance from time to time based on significant changes in market prices, which means selling the better performing asset class and buying the weaker performer in a given time frame.