Bonds can play an important role in your portfolio, but how do rising interest rates affect fixed income?
MARK RIEPE: As I'm recording this, a week has passed since my oldest daughter signed her apartment lease, and she's moving out of the house. A few days later, she started shopping at various thrift stores looking for quirky things that were both stylish and cheap, given the budget she had set for herself.
Watching her studiously reviewing prices of everything got me thinking about how everything does indeed have a price. Every good, service, or experience you purchase costs something to produce. And if we set aside complications like subsidies and loss leaders, that cost is reflected in the price, as well as how much consumers value the item.
But what about money itself? What is the price of money? The price of money is the subject of this episode. And that price is the interest rate. If we ignore charity and theft, if you need money that you don't have, then you can either work for it or borrow it.
If you work for it, the price of money is your time multiplied by your wage. If you borrow it, the price of money is the interest rate the lender charges you. In the spring and summer of 2022 interest rates have been rising. They've been forced up by the Federal Reserve as it attempts to bring down the rate of inflation. In other words, the Fed is raising the price of money to help bring down the price of everything else.
I'm Mark Riepe, and this is Financial Decoder, an original podcast from Charles Schwab. It's a show about financial decisions and the cognitive and emotional biases that can cloud our judgment.
This episode is about interest rates and how you should think about your fixed income investments in a world where interest rates have been rising.
Joining me is Kathy Jones. Kathy is a managing director here at Schwab and our chief fixed income strategist here at the Schwab Center for Financial Research.
Kathy has analyzed global bond, foreign currency, and commodity markets extensively throughout her career as an investment analyst and strategist, working with both institutional and individual clients. Kathy makes regular broadcast appearances on CNBC, Yahoo Finance, Bloomberg TV, and many other networks and is often quoted by The Wall Street Journal, The New York Times, Financial Times, and Reuters.
MARK: Welcome back, Kathy. Glad to have you here.
KATHY JONES: Glad to be here, Mark.
MARK: Kathy, after many years where interest rates have been quite low, rates are starting to increase. What's going on with that? What's happening?
KATHY: Well, there are several factors contributing to the rise in interest rates since late last year. First off, the economy is just much stronger than it was at the end of last year when, you know, we were still concerned about the lingering effects of the pandemic on businesses and hiring and on households. As it turned out, the economy rebounded much more quickly and more strongly than expected, and that caused inflation to rise. There's been more demand coming from consumers for everything from housing to services, things like hotel rooms, than there was supply, and that drove up prices. And then it was compounded by the energy price shock from Russia's invasion of Ukraine, and energy prices have really contributed to the inflation story this year. So as a result, the Federal Reserve started to raise interest rates earlier this year in the first quarter and is continuing to raise them in hopes of getting inflation down. The idea is that by raising interest rates, the Fed will slow down the economy so that demand and supply are in better alignment.
MARK: So give me an example of how that works. What are the underlying mechanics that causes that Fed action to have the impact on the economy that you just described?
KATHY: Well, here's an example. When the Fed raises rates, it means that borrowing costs rise across the economy. So, for example, borrowing money to buy a car gets more expensive. The interest payment on that car loan goes up. And as the car payment goes up, some people may decide they can't afford it, and they might hold off. As a result, demand for cars will start to fall. That may mean that automakers cut back on the amount of supplies that they buy and the hours of the workers who make those cars. And all that translates into a slowdown in the economy.
MARK: All right. So from an investing standpoint, we've got rates rising. You just talked about that. But what matters, you know, isn't so much what has happened, but what will happen. And, of course, nobody's got a crystal ball, but do you think interest rates are going to continue to go up?
KATHY: Well, when we're talking about interest rates, we're usually referring to short-term interest rates, those that are determined by the Federal Reserve. And we do expect them to keep going up because inflation is high, and the Fed wants to bring it down. And they've already told us that they plan to continue to raise rates until they see inflation come down. Inflation usually results from just too much demand relative to supply. So the goal of the Fed here is to slow down the demand side of the economy.
Now, the market is expecting short-term rates will go up to about 3.5 to 4% region in the next year or so. That's double where we are today, so that's a lot of increase. My personal opinion is that the Fed probably won't hike rates that much, because we're already seeing the signs that the economy is slowing down. So the peak in short-term interest rates could be closer to 3% than 4%.
MARK: So, Kathy, you've been talking about rates. And so for somebody who already owns some bonds, what happens to their returns when we see these kinds of changes in rates?
KATHY: Well, the return you get on a bond is always a function of the interest payments you receive along the way—we call them coupon payments, because bonds used to come with these little coupon books that you could use to redeem your interest—plus the value of the bond. So if you hold a bond to maturity, the return isn't going to change. But prices for existing bonds will tend to fall because investors want to buy the more recently issued bonds that have higher yields. So the price of the old bonds have to come down to make their yields more competitive with the newer bonds. So I'll give you an example.
Say you bought a five-year bond two years ago at par that was yielding 2%. You have three years left until the bond matures, so now it's effectively a three-year bond. Since interest rates have gone up over the past two years, the newly issued three-year bond would yield 3%. Well, no one wants to buy your bond because it only pays 2%, when you can buy a newly issued bond that pays 3. So the price of your bond will fall so that its yield is now close to the yield on a newly issued bond. It's just math.
Now, again, if you hold that bond to maturity and get your money back at par, then your yield to maturity will still be 2%. But if you want to sell it in the interim, then you'll likely get less than par in return and take a loss on the capital.
MARK: Kathy, the popular financial press talks a lot about the interest rate as if there's just one single interest rate that's kind of driving everything. But I've heard you say many times that, you know, there's really no one interest rate. So could you explain what you mean by that?
KATHY: Sure. You know, interest rates are simply the cost of borrowing, and that cost is usually determined by the length of the loan and the riskiness of the loan. And that's why there are so many different interest rates in the market. There's the short-term rate set by the Fed, which is the base rate for the financial system. But after that there are different interest rates for different types of investments or loans. The interest rate, for example, on a 30-year mortgage is typically higher than on a 15-year mortgage, because the bank or whoever holds that loan is taking more risk that you won't pay over a longer time period. Bonds are loans. When you buy a bond, you're lending money to the issuer, whether it's the government or municipality or a company. In general, you'll want to get a higher interest rate on a longer-term loan, because you're tying up your money for many years compared to a short-term loan. And if you are lending money to a borrower with a lower credit rating, you're going to ask for a higher interest rate to compensate for the risk they may default. So those are the two factors, the length of the loan and the riskiness of the borrower.
MARK: So when we read in the newspapers that the Fed is hiking interest rates, that doesn't necessarily mean that all rates are moving the same way, because of all these different factors you were just talking about. Is that right?
KATHY: Yeah, that's correct. Bond yields will, in general, tend to follow short-term interest rates in the early stages of a rate hike cycle. And that's what they have been doing. Ten-year Treasury yields have moved up from about 1.5% late last year to as high as 3.5% in mid-June. But in the past few weeks, bond yields have actually been falling, and that's because bond yields tend to be driven by those expectations for growth and inflation. And with the Fed hiking short-term interest rates to slow the economy, the bond market is now expecting less inflation longer term, and so yields on Treasury bonds have declined from the peak. Also, investors often shift money into bonds when they're worried about what's going on in the stock market, and that's been a factor, as well. But what I'm describing here is really the flattening of the yield curve, where the difference between short- and long-term yields will get smaller. That's usually a feature we see when the Fed is in the midst of hiking short-term interest rates.
MARK: Kathy, take a step back and maybe explain a little bit about yield curve. What do you mean by that?
KATHY: The yield curve describes interest rates for various maturities of bonds at a moment in time. So, for example, you know, we usually look at the yield curve in the Treasury market. On any given day, you can see what the yield is on various maturities, from very short-term T-bills to all the way out to 30-year bonds. That snapshot in time can give us a lot of information about how the market is looking at the future direction of interest rates.
Now, normally, yields will rise from the very short-term to the long-term. That's called the yield curve, and that usually is upward-sloping; those differences will move upward. But short-term yields tend to be lower than longer-term yields. But sometimes the shape changes.
MARK: So, normally, we've got an upward-sloping curve. Now it's been flattening, as you've just been describing, because the Fed is pulling up the short end of the curve, right?
KATHY: That's correct. So it usually flattens when the Fed is raising rates, and sometimes it even inverts, with short-term rates going over long-term rates. So, for example, right now, the Treasury yield curve is very flat, which, you know, again, often happens when the Fed is pushing up short-term interest rate. As they raise those rates, it signals that the economy will probably cool off and inflation will come down. And those are the factors that affect long-term bond yields. So the difference in yield starts to narrow, and at the peak of the cycle of rising rates, the yield curve is usually flat or even inverted, with short-term rates above long-term rates. And that is usually a sign the economy is at risk of falling into a recession.
MARK: Kathy, the Fed also owns a lot of bonds that it bought during the COVID crisis to help stabilize the economy. And it's been telling the market that it intends to actually reduce its holdings of those bonds. What impact, if any, is that going to have on interest rates?
KATHY: Well, in theory, it should mean that there would be some upward pressure on longer-term bond yields, since the Fed won't be buying those bonds at the regular Treasury auctions. And that means that other buyers—banks, mutual funds, individual investors—will have to take the place of the Fed. And since the Fed is indifferent to the price or yield where it bought the bonds, presumably private sector buyers will be a bit choosier. But it didn't necessarily work that way the last time around when the Fed did this. And that's because the economy slowed down, and bond yields fell anyway. There were more than enough investors willing to buy those bonds at lower yields.
So, ultimately, I think this process, which we call quantitative tightening, works more as a signal. It tells the market that the Fed is tightening up the amount of money it's supplying to the economy, and that can lead to expectations of less growth and less inflation. Sometimes things in the bond market are just counterintuitive, Mark.
MARK: So let's switch now, switch gears a little bit and talk a little bit about what investors should be doing, or at least looking at, with their portfolios. And maybe a good place to start is just remind listeners what role that bonds are playing in their portfolio.
KATHY: Well, there are three main reasons for holding bonds in a portfolio. The first is capital preservation. So barring a default, you'll get your principal and interest payments from a bond. So unlike other investments, you aren't at risk of losing your capital. The second is income. The majority of bonds pay income on a regular basis. And that's good for investors looking to generate an income stream, particularly for something like retirement, or simply to have that interest income reinvested over time. And that tends to make bonds a good tool for planning, since you have this predictable stream of income and principal payments. And then the third reason is diversification from stocks. Bonds tend to be less volatile than stocks, and at times their prices move in the opposite direction of stocks. Not always, but much of the time. Consequently, having bonds in a portfolio can help reduce the overall volatility, or ups and downs, in the portfolio.
MARK: We started out this episode talking about … actually, we've been talking mostly about, you know, the rising interest rate environment for bonds. Does the fact of that, does that change or influence the three roles that you just described?
KATHY: No, it really doesn't. Bonds still provide those benefits in a portfolio, whether yields are rising or falling. I mean, in the short run, during periods of rising interest rates, both stocks and bonds might decline in price. The bonds will fall in price because they're adjusting to higher interest rates. Stock prices might fall because when the Fed is raising rates, that tends to slow the economy and that's not good for corporate earnings, and that's what tends to drive the stock market. So, there may be less diversification benefit in the short run, but over the course of a total business cycle, the diversification benefit usually comes back.
And then the other factors remain the same. Bonds still generate income and provide capital preservation unless there's a default. And that's why we generally suggest that investors aim for keeping most of their fixed income holdings in core bonds. We call them core bonds, those with a very low risk of default, like Treasuries or investment-grade municipal or corporate bonds. Those types of bonds will tend to be a lot less volatile than riskier segments of the market, like high-yield or junk bonds or emerging-market bonds. So by allocating most of your fixed income portfolio to higher-credit-quality bonds with that low risk profile, that can allow you to actually take more risk in your stocks if you want to. Stocks will generally provide growth and capital appreciation, but they tend to be a lot more volatile. So having those bonds can let you ride out the ups and downs of the stock market.
MARK: Yeah, even for some bond portfolios, some bond indexes are down this year, but they're not down nearly as much as what you see with comparable stock indexes, right?
KATHY: Yeah, that's true. It's been a tough start to the year for bond holders. But, in general, any declines have been a lot less, maybe less than half of what you have seen in, say, the S&P 500® or the NASDAQ.
MARK: So given that, for someone who owns bonds in some form, what should they be looking at right now to determine if they should stay the course or whether they should be looking to make some adjustments?
KATHY: Well, if you've constructed a portfolio, you know, as part of an overall financial plan, you may not need to do anything if it's still working for you. You might want to take a look at the credit quality in the bonds that you're holding. Has there been any change there? Is it what you're comfortable with? And you might, you know, want to make sure that the interest income payments are meeting up with your cash flow needs. But, in general, there may not be much reason to make any changes if you've already put a plan in place.
MARK: Last question, Kathy. You mentioned the importance of having a high-quality core to your bond portfolio, and I think that makes sense for practically everyone, I think. But for those who are willing to be more adventurous with at least part of their portfolio, where are the best opportunities right now?
KATHY: Well, we think for investors who are willing to take some duration risk, or as we call it, interest-rate risk, then investment-grade corporate and municipal bonds with maturities in the 3- to 8-year range can look good on a risk-reward basis. In other words, they provide a decent amount of yield without an incrementally higher amount of risk of default. And those yields compare pretty well to what we could get just six months ago, and to dividend-paying stocks.
Now, if you're really more adventurous and willing to buy longer-term securities, you could consider preferred securities. They often have very long durations. Some are actually perpetual and don't have a set maturity date, although they might be called, but the yields are quite attractive, and we think the overall credit quality in the group is good. There are nuances to preferreds. So I think for anyone who is interested, we've written a number of articles on it that can describe them in more detail.
MARK: Kathy Jones is Schwab's chief fixed income strategist. Kathy, we always enjoy having you on the show. Thanks for being here.
KATHY: Thanks for having me, Mark. This is always the highlight of my career.
MARK: When faced with a stressful situation we often feel ourselves being pulled in two opposite directions. One part of us wants to do something—anything. We want to take some sort of action. Another part of us wants to pretend as if the stressful situation doesn't exist. We explain it away or dismiss it as not that important. Sometimes we deal with a situation by labeling it as transitory, a temporary inconvenience that will take care of itself.
All these tendencies are psychologically soothing in their own way. They also can make a lot of sense depending on the particular facts and circumstances of a situation. But reckless decisions or a head-in-the-sand approach is often a triumph of feelings over logic. Nevertheless, at the end of the day we feel the way we feel, and it can be hard to change those feelings.
Rather than try to change your feelings, augment them with a little analysis and then decide how best to move forward. In the case of your bond portfolio right now, a good place to start is to recognize that there's nothing you can do to change the past. Next, review the reason you own bonds or bond funds in the first place within the context of your financial situation, your cash flow needs, and your risk tolerance.
If your situation hasn't changed dramatically, and assuming your bonds will mature, the right answer may be to leave your overall allocation to bonds alone and not make any changes. Having said that, it always makes sense to review the specific holdings in your portfolio. What are the bonds and funds you own and do those still make sense?
Given the risks of recession and how a weakening economy will affect bonds of varying credit quality differently, it makes sense to look at your holdings and make sure you understand the risk and reward potential they present. Finally, we didn't spend a lot of time in the interview with Kathy talking about municipal bonds. One of the attractive features of muni bonds is their preferential tax treatment.
We also know that, for older listeners who are nearing or in retirement, this is a stage of life where leaving the work force could have a big impact on your tax bracket. It's also a stage of life where relocation often takes place, and that can affect taxes as well. For these investors, now's a great time to review the munis you own or potentially invest in munis if you haven't considered them in the past.
We covered a lot of ground in this episode, but there's no reason you have to face these decisions alone. Schwab has many resources for fixed income investors. You can find them at Schwab.com/FixedIncome. There you can learn about our managed solutions or how to manage your own income portfolio.
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For important disclosures, see the show notes and Schwab.com/FinancialDecoder.