Earlier this year, I did a quick write-up on the challenging market environment of 2022. I intended to dive deeper into the stock and bond market and share the context around that data and how it influenced our decisions when allocating portfolios. It was an opportunity to share our take on the money management side of things. With the current information cycle, it seems that more and more of the “market” discussion is framed as stocks, specifically, a few of the biggest names. If that only makes up a small part of your invested wealth, why should it be such a significant driver in the discussion? I wanted to use this article to talk about the non-stock portion of the world, more specifically, bonds. After all, it does have a notional value that is twice as large as stocks, and it can make up half or more of your portfolio, depending on your objective. While bonds come in many different iterations, there are some common themes that I wanted to highlight as we get into 2023.
Bonds are debt issued by companies and governments to raise capital. Rather than offering ownership, or equity, like stock investments, bonds provide a return of your principal over a given period with the promise of fixed interest payments. If a company goes bankrupt, in most instances, the investors with stock in the company have a total loss. Conversely, a bondholder may have a claim against some of the companies’ remaining assets and could stand to recover some of their investment. For these reasons, the expected rates of return on most bonds are far from where they would be for stocks because there is a less inherent risk in owning a company’s debt rather than their stock. If an investor requires a portfolio that does not have a lot of price volatility but does need to generate income, a diversified mix of individual bonds, bond mutual funds, or ETF’s can make a lot of sense. These holdings are typically listed in the fixed income section of your quarterly statement.
With that broad overview of bonds, it is important also to highlight what external factors impact bonds. The first risk is that the company or government that issued your bond is unable to make the payments. This is called default risk. If you build a portfolio of bonds with the hopes of living off the future bond interest payments, and they are not made, you have a problem on your hands. Looking at the issuer’s creditworthiness is imperative as the highest interest rate debt is typically offered that way because there is more underlying risk to that bond than, say a shortterm US government bond. The other major risk factor with bonds is interest rate fluctuations. We primarily focus on the fixed-income part of bonds, but they trade daily on the open market. The appeal of bonds is if you buy one for its face value, say $1,000, and you hold it to its term, you get your $1,000 back. Selling it on the open market before its maturity can have an impact on your principal, and that is largely due to fluctuations in the interest rate environment.
The rapid rise in interest rates we experienced in 2022 has been felt in many areas of life, but how does it impact bonds specifically? Let’s take an example where the 10-year US Treasury Note, a common benchmark for the bond world, is around 1.0%, like it was in January of 2021. You decided to buy a bond from a company for $1,000, which yields 4.0% per year. If the 10-year US Treasury Note in January of 2023 is now around 4.0%, do you think the same company would issue bonds to raise capital for their company at a higher rate than 4.0% or lower? The market would dictate that the interest rate on the new bonds would be much higher to keep up with market conditions. If you then looked at the trading price of the bond you bought back in 2021, it might be $800 rather than the $1,000 you paid because new similar bonds have been issued with higher interest rates.
The hypothetical example above was lived out in real life by fixed-income investors in 2022. With the Federal Reserve raising interest rates, which normally move up or down by a quarter of a percent, the equivalent of 17 times between March and December last year, investors holding fixed income saw the prices of the bonds they were holding drop in value substantially. Keep in mind this is only locked in if the bonds are sold. If rates have risen to a level to combat inflation where the Fed decides to hold and/or subsequently pull rates back down, that will positively affect the bonds investors hold.
The decisions of the Federal Reserve played into many areas of life. How it impacted our clients and the money we manage for them came up frequently, so I hope this was a helpful overview of the world of fixed income. It has presented opportunities for our firm to add meaningful exposure to fixed-income securities that should be well-positioned for the rate environment to come. We welcome the opportunity to discuss that further should you have questions.
Investing involves risk. No investment strategy can guarantee positive results. Loss, including loss of principal, may occur. Material discussed is meant to provide general information and it is not to be construed as specific investment, tax or legal advice. Keep in mind that current and historical facts may not be indicative of future results. Diversification is an investment strategy that can help manage risk within a portfolio, but it does not guarantee profits or protect against loss in declining markets.
This content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security. (C) Twenty Over Ten