What’s Going On With Bonds?

The bond market has generated considerable attention over the past year, and for good reason.

2022 represented one of the worst years in the bond markets in decades.  Why did that happen?  And what’s on the horizon?

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First, let’s explore some bond basics.

Bonds are a financial instrument issued by a municipality or corporation to raise capital.  The purchaser of the bond lends the issuer money, and in return, the bondholder often receives interest (coupon) payments throughout the term of the bond, and then receives the initial purchase price back at the maturity of the bond.  Bonds can be categorized in a few different ways.  The most common categorizations are based on length to maturity (short, medium, or long-term) and bond rating (how likely the bondholder will be paid back by the issuer).  Bonds can be rated from high-quality, no risk bonds (i.e. US Treasuries) to junk bonds.

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The main driver behind the volatility in the bond markets last year was due to the rising interest rate environment felt in the US and around the world.

Bond prices and interest rates have an inverse relationship, meaning that existing bond prices fall when interest rates rise.  Why does this happen?  It’s actually quite simple – the economic forces of supply and demand are at work.  When interest rates increase, consumers tend to sell existing bonds that have lower interest rates and purchase the newer bonds with higher rates.  Because so many existing bonds are sold, the prices of the bonds drop.  When the prices of a bond drop below their par (maturity) value, they are coined as being sold at a “discount.”  When interest rates decrease, we see the exact opposite effect.  Existing bond prices increase because consumers want to purchase the bonds with a higher coupon rate, driving the price up.  When bonds are bought or sold at a price higher than their par (maturity) value, they are classified as being bought or sold at a “premium.”

The rate of return on a bond is calculated by using the interest payments being received, plus the appreciation of the bond to par value if the bond was purchased at a discount.  If the bond was purchased at a premium, the depreciation to par value must be factored in.

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For decades, bonds have been used as the “conservative” part of the traditional investment portfolio.

Should the increase in interest rates change that perception?  Not necessarily.  It’s critical to focus on maintaining the right allocation between stocks and bonds with a long-term time horizon in mind.  It’s easy to get caught up in the emotions of short-term price movements, whether those happen in the stock market or the bond market.  History has proven that maintaining the proper amount of risk for a long period of time gives investors the highest probability for success in their situation.

Although rates will likely increase throughout the upcoming year, bond holdings may still be a necessity in your portfolio.  Make sure to reach out to our team of planners if you have any questions regarding the allocation that’s right for you!