January 2022 was a month of significant price volatility for stocks. Since rising interest rates/inflation continue to be mentioned as important factors in this stock price volatility, and these same factors influence changes in bond prices, we are focusing this month on bond price volatility.
In the financial markets, volatility refers to the extent to which prices fluctuate, both up and down, in a given time frame. The greater the fluctuation, the higher the volatility. In January 2022, stock prices (S&P 500) went from a closing high of 4,796 (on January 3rd) to a closing low of 4,326 (on January 27th), a variance of 451 points, or approximately 10%, in less than one month. Intra-day variances were as much as 5% (on January 24th). This constitutes significant, and harmful, downside price volatility. We say this because whenever stock price changes make long-term investors (as distinguished from short-term traders) want to even partially abandon their long-term allocations to stocks for fear of continuing declines, volatility can be harmful.
We of course recognize that financial market prices vary all the time, but we encourage our clients to focus on the long term as much as possible. As Jason Zweig wrote in his recent Intelligent Investor online column, “Why You Should Sit Out the Mayhem” (WSJ, 1/25/22): “What matters most isn’t what the market does – but what you do in response.” Zweig then quotes from his own 2014 writing: “Individual investors should tune out the futile efforts by commentators and strategists to extrapolate the market’s latest swings into a prediction of what will happen next.”
We discuss stock prices first because historically it is their volatility, both up and down, that provides one of the strongest rationales for owning bonds as part of a broadly diversified investment portfolio. While stocks have had three multi-year declines exceeding 40% since 1970, the largest of three annual down periods for bonds was negative 5% in 1994 (data from Ibbotson, Duff & Phelps, 2020 Yearbook, page 2-9; more detailed data from Ibbotson on the extent of stock and bond price volatility will be presented in future Comments). But since bond prices do change from day to day, it is useful to understand how bond price volatility differs from stock price changes. For this discussion, we will make some preliminary observations and then quote extensively from a recent NY Times article (1/31/22, page B1 and continued).
1) Bonds are investments in which lenders provide money to borrowers, typically companies and governments, and the borrowers promise to repay the money at a specific date in the future. The borrowers also pay interest to the lenders while the bonds are outstanding.
2) Bond prices fluctuate while they are outstanding, with the changing level of market interest rates being the major determinant of bond price changes. When interest rates are rising, bond prices fall because the investor can buy either the existing bonds with lower interest payments or newly issued bonds with higher interest payments. The lower prices for existing bonds compensate investors who buy the lower interest payments. Conversely, when interest rates are declining, prices for existing bonds rise.
3) Overnight, “ultra short-term” interest rates in the US are set by the Federal Reserve. Longer term interest rates, starting with even a few weeks, are established by financial market participants who buy and sell bonds.
4) Bond maturities impact prices. Maturity refers to the time when the principal amount of the bond is due to be paid. The longer in time until maturity, the more price fluctuation, because the owners of the bonds have to wait longer before they can get their money back to reinvest at the new interest rates. When rates are rising, longer maturity bonds are likely to decline more than shorter maturities; conversely, when rates are falling, longer maturity bonds should gain more in price than shorter-term bonds.
5) Credit quality affects prices. Credit quality refers to the likelihood that the bond issuers will pay interest and then repay principal at maturity. Bond issuers include the US and international governments, state and local governments in the US (which issue “municipal” bonds), and businesses. All these borrowers are looking for sources of money to finance their various activities. Governments, especially national governments, tend to have the highest credit ratings, since they have the power to tax and print money, albeit with political and economic limits to each. Business borrowers have wide differences in credit quality, depending on their financial stability. All other characteristics being equal, the higher the credit quality, the higher the price of the issuer’s bond and the less interest they have to pay to attract investors. Some credit quality is so low that the bonds are referred to as “junk bonds,” but these bonds typically pay much higher interest than the higher credit bonds to compensate investors for the higher risk of nonpayment.
6) Although rising interest rates lower bond prices, the buyers of the new bonds receive the benefit of the higher interest rate payments. These higher rates typically offset price declines over some period of time.
7) One key reason the Fed raises interest rates is if the economy is growing too fast, generating undesirable rates of inflation. Higher interest rates tend to slow the economy down, which in turn lowers the rate of inflation. Our December 2021 Comments provided a table of contents for all 2021 Comments, where we frequently discussed the current connection between interest rates and inflation.
We now turn to the NY Times article referenced above (1/31/22, page B1, titled “US Bonds Hold Appeal Despite Yields”, and page B3, titled “Inflation and Deficits Don’t Dim the Appeal of US Bonds”). “Headlines are proclaiming that government bond yields are near two-year highs. But the striking thing about bonds isn’t that yields – which influence interest rates throughout the economy – have risen. It’s that they remain so low. In the past year, with consumer prices rising at a pace unseen since the early 1980s, a conventional presumption was that the demand for bonds would slump unless their yields were high enough to substantially offset inflation’s bite on investor’s portfolios. Bond purchases remained near record levels anyway, which pushed yields lower. The yield on the 10-year Treasury note – the key security in the $22 trillion market for US government bonds – is about 1.8%, roughly where it was on the eve of the pandemic or when Donald Trump was elected President, or even a decade ago, when inflation was running at a mere 1.7% annual rate – compared with the 7% year over year increase in the Consumer Price Index (CPI) recorded in December.”
“Because the 10-year Treasury yield is a benchmark for many other interest rates, the rates on mortgages and corporate debt have been near historical lows as well. And despite a binge of deficit spending by the US government – which standard theories say should make a nation’s borrowing more expensive – continuing demand for government debt securities has meant that investors are, in inflation-adjusted terms, paying to hold Treasury bonds rather than getting a positive return.”
The article then offers possible explanations: “The major reasons for this odd phenomenon include long-term expectations about inflation; a large (and unequally distributed) surge in wealth worldwide and the growing ranks of retiring baby boomers who want to protect their nest eggs against the volatility of stocks (PPA emphasis) … Several major market participants attribute these stubbornly low yields, in spite of a high growth, high inflation economy, to a widening sense among investors that a time of slower growth and milder price increases may eventually reassert itself.” (PPA note: while our regular readers know we avoid attempts to explain certain financial market events or to predict the future, we are including the views in this article because we think they are relevant to this discussion of bonds.)
In Park Piedmont’s view, bonds do provide a cushion against the much higher volatility of stocks. Bonds are a necessary component of a well-balanced asset allocation suitable for clients and their particular needs and goals. Even if we are entering a period of higher, more normal interest rates, remember that the Fed has yet to raise its rate even once, let alone three or four times, and that the actual rates of short and intermediate bonds, actively traded daily, are still quite low by historical standards. How high the 10-year yield needs to go to cover the Fed’s anticipated actions remains to be seen. Further, the strength of the economy in the recovery from the pandemic is still unclear and will impact interest rates. And remember the silver lining of higher interest rates: as a bond investor, you get the advantage of receiving higher interest payments, which have historically offset price declines over time. We continue to advise maintaining the asset allocations established in calmer times, and reevaluate allocations for possible rebalancing as market prices change.