In the Money Insight: Bonds, Yields and Inflation
Matthew Navickas, AAMS?, a member of our Research & Trading Group at Falcon Wealth Advisors, joined me on?In The Money Insight?to discuss how the current inflationary environment is impacting bonds and their yields, why we’re still investing in bonds, and more. A summary of our conversation is below.
Cory:?To start us off, can you talk about the relationship between bonds and interest rates?
Matthew:?Sure. When interest rates rise, as they have in recent months, the value of bonds decreases. It’s an inverse relationship. However, bonds also yield more interest as interest rates rise, which can benefit investors who buy individual bonds and hold onto them until they reach their maturity date.
Cory:?Looking at the big picture, for the most part, interest rates have been declining for the past few decades. So why are they going up now?
Matthew:?We should first note that when interest rates were low, people (and the government) were able to borrow money easily. Zero interest rate policy led to an overstimulated economy and it’s a part of the reason we’re now experiencing such high inflation.
One of the tools the Federal Reserve can use to try to cool off inflation is to raise the interest rates it controls. Rising interest rates makes it harder for both consumers and businesses to get access to capital, and the Fed hopes this will slow inflation, by bringing down demand.
Cory:?Indeed. Regarding how interest rates affect bond yields, traditionally, if you’re willing to invest in a bond that matures in 10 years rather than two years, you’re going to earn higher yields on that 10-year bond. This is referred to as the yield curve, as the chart below shows.
As you can see, the curve is flattening beyond three years or so. What does this mean, Matthew?
Matthew:?One thing it means is that investors are likely concerned about the amount of risk they would be taking on if they invested in the stock market, so they’re choosing to invest in short term bonds.
Cory:?Yes, and investors don’t have a ton of incentive to invest in long-term bonds, as those bonds are not offering higher yields than short-term bonds. The global bond market—which is larger than the stock market—is not “pricing in” long term economic growth or inflation expectations beyond the next 18-24 months.
So why should an investor own bonds in the first place?
Matthew:?Bonds are important, especially for people who are retired or nearing retirement. Even in this environment, we want clients to have 5-10 years’ worth of living expenses invested in the bond market. The reason for this because the bonds provide a predictable income stream via interest payments (regardless of a bond’s value any given day) and principal is returned at maturity. While we don’t like to see bond values decline, if the bonds you own are from stable companies and governments, the value on a day-to-day basis is less critical. Bonds are a diversifier and help to generate income in a turbulent environment.?
Cory:?Bonds are indeed an important part of a diverse portfolio, as they behave differently from stocks in times of crisis. And as you mentioned, they can offer a predictable income stream for retired clients.
And while bonds are decreasing in value, they’re also yielding more interest than in previous years. As the bonds clients own mature, we can take the principal they’re returned and reinvest it in different bonds that are paying higher interest.
Can you talk about the types of bonds we invest in, Matthew?
Matthew:?We don’t take an overly aggressive position on bonds. We look for high quality, investment grade companies that are paying interest rates worth our investment. We can use software to learn more about a company’s default risk and we of course do significant research into all the companies we invest in, whether it be through stocks or bonds.
Cory:?While the bond market is both large and complicated, people should know there are different types of bonds. As you mentioned, we buy investment grade bonds for our clients. What does that mean? It’s related to how credit rating agencies issue a credit rating to companies that issue bonds—it’s kind of like how individuals have credit scores. Bonds that are considered investment grade are issued by companies that have been deemed unlikely to default on their obligations.
We don’t want to take on too much risk on the bond side of the portfolio, as the risk/reward calculation there is much different than on investments in the stock market. We typically take more risk on the equity side of the portfolio. And we don’t target riskier bonds, often called “junk” bonds. We focus on bonds from quality companies and stable governments.
Can you talk about credit spreads, Matthew, and their relevance to the market?
Matthew:?Analyzing credit spreads involves comparing a US Treasury bond to other types of bonds—for us at Falcon Wealth Advisors, this often means corporate bonds. The spread refers to the delta between a UST and a corporate bond with a similar maturity date. The spread between those two yields provides us with information about the riskiness of the corporate bond.
When credit spreads widen, and the delta grows larger, this tells us investors are avoiding risk in the market and they don’t consider the yields on corporate bonds to be worth the added risk vs Treasuries.
Cory:?I watch credit spreads closely, as they can also be an insight into the overall market environment. But just as there can be mispricing in the stock market, there can be price dislocation in the bond market.
An example would be in the first quarter of 2020 at the onset of the pandemic. As the stock market fell about 35%, credit spreads widened. In fact, credit spreads got?so?wide, credit (bonds) from some of the safest businesses and institutions in the world became mispriced. At Falcon Wealth Advisors, we took advantage of this opportunity and purchased bonds from companies that were yielding much higher interest rates than usual. We can take advantage of both mispricing in the stock and bond market.
Matthew:?Yes, I recall when we bought those bonds and watched them appreciate by as much as 10% in the following six months. We’re constantly looking for opportunities like that for our clients.
Cory: And we’re able to take advantage of these opportunities because we buy individual stocks and bonds. We couldn’t do the same thing if we used bond funds.
It’s worth noting that while bonds are considered a “safer” investment, no investment is guaranteed. There have been times when bond holders have not received their principal back on the date they were supposed to. That’s why it’s critical to work with a fiduciary wealth advisor who does the appropriate research. At Falcon Wealth Advisors, we work to prepare client portfolios for volatility before it happens and then we work to take advantage of volatility once it arrives.
Let’s now talk about inflation. How does inflation impact bonds?
Matthew:?We may earn anywhere from a 2-5% yield on a bond, but if inflation is over 8%, purchasing power with bond interest is diminished. That’s why we’re focused on buying bonds with shorter maturity dates so that we can regularly re-invest bond principal in new bonds that are earning higher interest. Like everyone, we hope to see inflation cool off. It would be nice to buy a bond yielding 4% while inflation is at 2%.
Cory:?Well said. Inflation erodes purchasing power, but bonds typically yield higher interest as inflation rises.
Lots of people are opining about when inflation could peak, but I would like to offer a reminder that no one knows. At Falcon Wealth Advisors, we don’t pretend to know exactly what’s coming next. But what we can do is prepare detailed, customized financial plans for our clients that allow us to preserve capital and manage risk while being opportunistic.
Dealing with market volatility is the price of admission for achieving the returns the stock and bond markets have historically delivered. The current environment is not pleasant, but it’s also not unusual. At Falcon Wealth Advisors, we were not caught off guard by this market correction.
Matthew:?While it’s hard to stomach market volatility, to be able to sell high, you must be willing to buy low. And right now, is likely a prudent time to buy low on the stock side of the portfolio.
Cory:?Can you expand upon what we’re doing for clients at Falcon Wealth Advisors during this period of volatility?
Matthew:?We’re focusing on the facts we know, and that is that the Federal Reserve is going to continue to raise interest rates. That’s why we’ve shortened the bond ladder so that we can get principal back sooner and invest it in bonds yielding even more interest as interest rates continue to climb.
Cory:?We are indeed focusing on buying shorter-term bonds for clients. We also watch the default risk of all the companies where we’re invested, whether it’s stocks or bonds. And we have several institutional research partners that provide us useful information that we review each day. All of these items inform the choices we make for our clients. We’re not beholden to any one way of doing things. We can instead focus on making the most prudent decisions possible with the information we have.
Thanks so much for joining me, Matthew. If you want to learn more about how bonds can play an important part of your portfolio, please contact Falcon Wealth Advisors today. You can reach me directly at?[email protected].
Clients choose to work with us to enhance their financial literacy and explain exactly what?their?financial plan means to?them.
Securities offered through Hightower Securities, LLC, Member FINRA/SIPC,?Hightower Advisors, LLC?is a SEC registered investment adviser.?brokercheck.finra.org
?2022 Hightower Advisors. All Rights Reserved.