So far, 2022 has brought us one of the steepest downturns in bond market history, as several factors have caused a rapid repricing of existing bonds. The goal of this blog is to define several bond market terms and simplify some of the mystery of the bond market and how it is affected by interest rates and credit ratings.
Let’s start by getting some terminology/jargon on the table.
Bond is a fancy term for a loan and is a type of fixed-income investment or security. An entity—we will use ABC Corp.—will issue bonds to the public, typically to raise funds for some type of project, investment, or expense.
When the ABC bond is sold, ABC will receive the principal (the base value of the loan) and the purchaser will receive the issuer’s promise to repay the principal amount at a stated maturity date in the future.
To compensate the purchaser (let’s call her Sally) for the use of her dollars, ABC will also promise to make coupon payments to Sally. These payments typically happen semiannually and at a stated interest rate that is set as part of the original issuance.
Let’s use the following as our sample bond characteristics:
- Issuer – ABC Corporation
- Purchaser – Sally
- Principal – $1,000 (priced @ $100/bond = 10 bonds)
- Maturity – 5 Years
- Interest Rate – 4%
Let’s look at a visual timeline of this bond transaction:
You can see that Sally loaned $1,000 to ABC, and ABC paid her $200 to borrow her $1,000 for five years.
Now that we have defined the initial terms of our bond transaction, let’s see what might affect that bond in years one through five. After the first year, our maturity date naturally rolls down to four years, shortening the amount of time before the loan is repaid in full. It’s important to note that all bonds naturally progress toward their maturity date.
Let’s get one more term defined before we continue. Yield is commonly used to address total return of a bond. Assuming the principal is repaid in full, the yield will be the same as the interest rate at the issue date. However, the price of a bond ($100 in our example) can change after the initial sale. So, yield is technically a function of two things: the bond’s stated coupon or interest rate and its price at the time.
Here is simple way to think about it:
- Yield = coupon payment/bond value
- When applied to the ABC/Sally example, here is how it looks:
- 4% = $40/$1,000
Pretty simple, right? But what happens to the yield math when the current price of the bond changes? Let’s say something happened and the price of this ABC bond goes down to $90/bond.
Here’s how the current yield changes:
4.4% = $40/$900
Since the current value of the bond is lower, the yield goes up, in this case by 0.4%. The opposite is true as well:
3.6% = $40/$1,100
The only thing changing in the above example is the current price.
Remember, markets move around all the time and while the bond market tends to be much less volatile than the stock market, it has its own risks. Without a little risk, we wouldn’t expect to be paid much in return.
Now let’s define common risk factors that affect bond pricing.
- Term Risk—Term risk covers all the things that might happen during the life of the bond. The term is meant to relate the amount of time Sally is owed money.
What happens if ABC Corp. has a couple surprisingly bad years and there are now questions around its ability to make its payments to Sally? Or what would happen if the Federal Reserve decided it’s time to raise the federal funds rate and the bond market moves accordingly?
- Credit Risk—This term is generally meant to help investors determine how likely the issuer (ABC Corp.) is to fulfill its part of the deal (make the agreed upon coupon payments and repay the principal at the stated maturity date). For the most part, if ABC Corp. fails to make any of its payments to Sally, it would be considered in default, a legal term that is usually followed by a creditor workout. There are several credit agencies that are paid to determine issuer creditability, most notably Standard & Poors, Moody’s, and Fitch. Below is a sample of the ratings scale.
Let’s look at the change in credit first. We will assume that when our bond was sold, ABC Corp. was rated a stellar AA+ at S&P. In year three, after ABC’s poor performance, S&P downgrades ABC Corp. to AA-, essentially showing they are a bit less likely to make their payments to Sally. It would make sense that this would affect the price of all of ABC’s outstanding bonds, right? You are now loaning money to a less credit-worthy issuer. If you were buying a new bond, you would demand a higher return, as you are now taking on more risk. You see the demand for higher payments in the yield too. Remember our yield equations? This one fits here:
4.4% = $40/$900
Think about it in the context of “Sally needs her money back early.” She would need to find someone to buy her bond, and at the lower price the yield is slightly more attractive than the initial transaction, compensating the buyer for the additional risk.
Interest Rate Risk
Now let’s look at the second scenario, the Fed decides to raise the federal funds rate, which is the rate the Federal Reserve charges banks to hold their money overnight. It essentially sets the standard for the one-day yield.
For easy math, let’s use our AA+ rated ABC Corp. (This time the company performs just fine and keeps its rating.)
Sally’s initial bond purchase was at 4%. In year three, the federal funds rate shifts upward. ABC Corp. now has to issue its bonds at a higher interest rate. They start offering the same deal Sally had, but at a 5% interest rate. So let’s have Tom buy this new bond.
The yield equation would look like this:
5% = $50/$1,000
Given our assumption that ABC’s credit hasn’t changed, what does this new issuance mean for Sally? Well, if Tom can get a 5% bond, in order to compete Sally needs to offer the same yield, 5%. The only way to adjust the yield when the coupon is constant is to change the market price.
Here is a look at the math:
5% = $40/$800
You can see that this lift in interest rates has had a negative impact on the price of Sally’s ABC bonds. She loaned $1,000, but it’s now worth $800.
This scenario shows the effect of a changing market interest rate on existing bonds. Bond prices have an inverse relationship with market interest rates. If market rates go up, bond prices fall, and vice versa.
Time to get another term defined. Duration measures the amount of time (on average) it takes for the issuer to repay its obligation to the borrower. At this point, you would think a bond’s duration is the same as its maturity date, but that isn’t technically correct. Since ABC Corp. has to make its coupon payments during years one through five, Sally gets a little bit of her money before the five-year maturity date, bringing the amount of time “on average” down. The reason why this term is so important is that duration is commonly used to determine a bond’s sensitivity to changing market interest rates.
As a rule of thumb, if interest rates were to go up 1%, a bond’s price would go down 1% for each year of duration left. So for a bond with a five-year duration, its price would go down 5% for each 1% increase in interest rates. A bond with a 10-year duration would decrease 10% for every 1% increase in interest rates and so on. All of this should make sense; longer dated bonds tie up principal for longer terms and the possibility of markets changing is greater given the additional term. This is also the reason why longer dated bonds tend to offer higher coupon rates, because investors require additional compensation (higher yields) for the additional term risks.
Now you can see the two main drivers of risk and return while investing the bonds, credit risk and interest rate risk. The possibility that market rates or the issuer’s creditability will change during the lifetime of a bond are risks and the total yield is the payment for enduring those risks.
Bond Market Rates and Performance
To conclude, let’s tie all these terms back to what is happening in 2022 in the bond market.
Let’s start with some perspective. From 12/31/1999 to 12/31/2009, the 10-year Treasury offered an average rate of 4.46%. During the next decade (12/31/2009 to 12/31/2019), the average rate fell to 2.40%, a 46% decline. The 10-year is yielding 2.78% today.
Since 2001, the federal funds rate hit a high of 5.25% in the third quarter of 2007 (pre-Global Financial Crisis or “GFC”). By February 2009, federal funds rate hit the “zero-bound range,” or “ZBR” essentially taking it to 0%. It stayed in that range until 2016, when the Fed started lifting its rate to a 2.43% peak in 2019. Then, as we all know too well, COVID hit. As the economy slowed, the Fed dropped its rate back to the “ZBR” in an attempt to spur economic output. (The federal government also issued a historical amount of stimulus based on a similar rationale.)
Now we have established a couple things:
- On average, yields on fixed income investments have been below their long-run average for over a decade.
- The federal funds rate has been in the “ZBR” twice since 2000.
That said, there are more things to point out. Low rates, material stimulus, and an economy dealing with post-pandemic growing pains (low labor participation, tight labor market, etc.), all put upward pressure on the price of goods and services. The Consumer Price Index (CPI) is how economists track these pressures. The CPI tracks a relatively constant basket of goods and services to note changes in prices on an aggregate basis. Upward pressure on prices is the general definition of inflation.
When prices of basic goods and services increase, the result is you get less goods with $1 than you could yesterday, which is called inflationary. Now, inflation is a topic that deserves its own post; we do know that if inflationary pressure gets too strong, it’s hard on consumers (they can’t afford as much as they used to) and eventually it becomes harmful to the overall economy as consumption and output are adjusted to compensate.
We know the Federal Reserve dropped its overnight rate during the GFC and the pandemic to help spur economic growth. Central banks can use their overnight rate to either tighten things up (raising rates) or make it easier for money to flow (lower rates). Over the last six to eight months, we have seen large increases in CPI, and as a result, the Fed has signaled that it will raise its overnight rate to help dampen the upward pressure on prices. As the Fed lifts its rate, you can see the effect on newly issued 10-year Treasuries; their issue rate has moved from 1.63% at the beginning of 2022 to 2.78% (as of 5/23), a 70% increase!
The lesson here is that while bond owners will likely see the prices of their bonds decline in value as the rates of the overall market move up, there is a bright spot. If the bonds are left to mature, the interim changes in market prices aren’t an issue and they will still get their principal returned with the coupon payments at the maturity date. Once rates level out, the overall bond market should see higher yields going forward as new bond issuance will happen at higher yields, meaning higher cash payments to investors.
We encourage every investor to work with their financial advisor to understand the purpose of their long-term asset allocation, i.e., the mix of protection-oriented assets versus growth assets. At Columbia Pacific Wealth Management, we help our clients understand bonds, manage risk through diversification, and integrate bonds into structured portfolios. Please contact one of our wealth consultants to learn more about bonds, risk management, and other strategies.
Important Disclosure Information:
Different types of investments involve varying degrees of risk, including the risk of loss of your entire investment. Past performance is not indicative of future results. All opinions expressed herein are current only as of the date hereof and CPWM and its employees can give no assurance that the performance of any specific investment recommendation or investment strategy discussed herein, whether directly or indirectly, will be profitable, or that it will be equal to any historical performance level discussed herein. The discussion or information contained herein is not intended to be, and should not be deemed as, personalized investment advice. The recommendations made may not be suitable for your specific individual situation and we encourage you to discuss with your financial professional before undertaking any investment strategy or recommendation contained herein. The discussions contained in this blog is current only as of the date hereof and may change due to a number of factors, including varying market conditions.