With multiple comments over the last few weeks and a pick up in headlines concerning interest rates, we decided to do an analysis and review! We also have added a video to help explain some of the complexities associated with rates and bonds … as while at face value bonds are a simple animal, their movements can be puzzling.
The main reason for the increased headlines and comments are when rates go up, the value of bonds goes down initially, and rates have really jumped dramatically for various reasons.
Briefly as a reminder, Bond aka Fixed Income aka corporates aka treasuries aka high yield aka Fixed Income instruments are nothing more than a note with an income stream to the purchaser of the bond! There is a saying the bond market is “Smart” because you only have to worry about the ability and willingness of the lender to pay… nothing else…
Rates and Bonds – I Go Up, You Go Down
The Green line is the yield on the 10 year treasury… The red is a huge bond fund from Vanguard called the BND….
No doubt that this is an almost perfect inverse relationship.
One detail worth mentioning, longer term bonds are more volatile, both up and down than shorter term i.e. A one year bond will not move near as much as a 30 year. This makes sense because the longer the term, the more payments that are owed and the more change in the prevailing rate effects the bond.
Fast Fast Fast Movement
In true, be careful what you ask for fashion, (we have long been positive towards higher interest rates) rates have moved incredibly fast, especially Mortgage Back Securities which are pools of mortgages used for determining current new rates…
This is the average 30 year fixed rate mortgage…. as of yesterday, this rate was well over 5%…this rate is almost double the rate just a few quarters ago…. With eventual supply, our home asset is facing some headwinds !
Much of this rate movement is coming from Federal Reserve Bank Presidents public comments…..
Why would they do this? To slow the economy… if they can get the market to move rates up, their job is easier ….heck if they can get market participants to do all the work, the Fed would hardly need to do anything… plus markets are much faster to react than the FOMC (Federal Open Market Committee)
Once interest rates move, a new bigger income stream is the net effect… New purchases or re-investments are met with bigger income payments…
This continued higher income payment begins paying back the headwind of the drop in value as shown in the first chart…
Clipping that coupon will be nicer as rates increase!
How Far Can they Go? Rates and the FOMC?
Here comes is the sizzle…. be careful on extrapolating higher rates into the future… this extrapolation has garnered a lot of headlines as of late …. Whoaaaa
This is about a 35 year chart… go back farther, to a much younger demographic, there was a time when the FOMC raised interest rates to the roof… think 15-18% to tamp out inflation….
With an economy today of much more debt to service and older (more savers, less spender) demographics the last four decades have been a slow but continued lower longer term rate….
Note the top of the prior interest rate cycle looks like the top of the FOMC rate hike…again the last four decades….
With the afore mentioned cycle high repeating as the following cap on rates, looks like, although very fast rate movement recently, the majority of the move is likely over….and therefore less headwind for the value of bonds and bigger coupons….
Lastly… a slowdown in economic times or a rush for the safety of our simple friends usually leads to a reversal in rates and a repeat of the afore mentioned process…but in reverse… lower rates, higher prices!
Have a Great “Bonds and Interest Rate Analysis” Day!
John A. Kvale CFA, CFP
Founder of J.K. Financial, Inc.
A Dallas Texas based fee only
Financial Planning Total Wealth