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Some Pleasant Arithmetic Behind Falling Prices

A few years ago I wrote a post about how I was having trouble constructing portfolios that could meet a conservative 4% rate of return. With bond yields near 0% across so much of the global bond market it was becoming increasingly common to hear that “3% is the new 4%” withdrawal rate. But with the recent bump in interest rates the story has changed dramatically and as is so often the case, lower prices today mean better returns in the future. Let me explain.

One thing I love about high quality bonds is how they tell you all the information you really need to know about the future. For a high quality bond (like a T-bond) you know the exact maturity date, its current price, its future returns and its credit risk. For example, if you buy a 2 year T-Bill today because you have 2 years of cash flow uncertainty that you don’t want to leave in a 0% money market account then you know with exact certainty that you’ll earn about 2.5% per year for the next 2 years. Sure, your inflation adjusted return will be negative, but we hold cash and bonds because of intermediate uncertainty, not because of inflation protection. If you want full inflation protection I regret to inform you that you need to own longer & more inherently risky assets (like real assets, stocks, etc). Further, the bond yield jump will cause your bond prices to fall in the short-term. 

It’s not all bad news though. Yes, rising interest rates cause bond prices to fall in the short-term, but they also create higher future returns in the long-term. The same basic concept can be applied to the stock market (and explains why you typically want to “buy low”), but it’s easier to communicate in bonds because the arithmetic is cleaner. So, for instance, if you owned a 1 year T-Bill 1 year ago you owned an instrument that paid you 0.06% per year. When interest rates rise by 1% the day after you buy your T-Bill you lose 1% of its value. You have an immediate loss of 1%, but you can now own an instrument that pays you 1% and has the exact same credit and time horizon as the instrument you used to own. In other words, you can now roll your T-Bills in perpetuity by incurring a short-term loss for long-term higher returns. This is painful in the short-term, but it’s great news in the long-term.

Or, consider a laddered constant maturity 5 year bond portfolio that currently pays 2%. And then consider the same bond portfolio, but interest rates jump 2% the day after you buy that bond. If the portfolio has a duration of 5 you will lose about 10% overnight. Your $100 bond portfolio instantly turns into a $90 portfolio. This is brutal in the short-term, but it’s great news in the long-term. After all, your bonds will now start to rollover into the higher yielding bonds over the course of the next 5 years. In fact, if you hold that portfolio for 7 years you will now earn $118 over this period vs $115 if interest rates had never changed. So, you’re better off in the long-term even though you’re worse off in the short-term.

Of course, this is what all of investing is all about – a temporal conundrum. We are constantly being tested by our short-term emotions and financial needs. This is why asset-liability matching is such an important part of the financial planning process. If you don’t properly match your financial assets with your behavioral limits and liability needs then you’ve created a portfolio that isn’t behaviorally robust and is prone to behavioral biases (like selling low and buying high).