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So today as I was sorting through the news and trying to find SOME topic that didn’t have the words “Trump” and “shithole” in it and I stumbled across this on CNN.
A sell-off in bonds could be “the Armageddon event for this year,” Naeem Aslam, chief market analyst for Think Markets UK, wrote in a report Tuesday.
Did you hear that? Armageddon, people! Nothing good is associated with the word “Armageddon.”
And as usual when something that alarming is in the news, my inbox starts getting blasted with people asking me about it, and sure enough it happened. “Bond bubble? Armageddon? Should I sell off all my bonds? GAAAH!”
How Bond Pricing Works
Now, everyone generally understands how equity pricing works. If a company’s expected to do well, it’s stock price goes up, and if a company’s cocking things up, it’s stock price goes down. Up is good, down is bad.
But for bonds, it’s a little more complicated, and somewhat unintuitive, so first, let’s recap how bond pricing works.
Bonds are issued by the government of that country at an interest rate set by that country’s central bank. But how much that bond is actually worth is determined by the bond market, not the issuing government.
The bond market, meaning the combination of all bond traders out there, look at factors like the bond’s duration, interest rates, and the quality of the lender to decide how much they’d actually be willing to pay for that bond.
When a bond’s price goes up, that means its yield went down. This is because if a bond is paying a certain fixed percentage income (known as its coupon), and you ended up paying more for it than the last owner, than you’re effectively getting a lower yield since the underlying bond’s coupon hasn’t changed. Conversely, if a bond’s price goes down, its yield is going up since you were able to buy that bond for less money than the last guy.
So when the news is screaming about “YIELDS SHOOTING UP” that’s actually bad for existing holders of those bonds because it’s value is going down. Similarly, if “YIELDS ARE PLUMMETING,” that’s actually good for existing bondholders since their existing bonds just got more valuable.
Now, the factors that can’t change (like duration) are priced in at the time of issue. But the factors that can change (like interest rates) are the factors that can swing the bond market in one direction or another.
If central banks raise interest rates, this will cause bonds’ (and bond ETFs’) yields to rise as well, which pushes their price down. Conversely, if central banks lower interest rates, yields will fall and push bond prices up.
The Bond Bull Market
Ever since the Great Financial Crisis of 2007/2008, central banks have been dropping interest rates into the gutter in an attempt to stabilize and stimulate the economy.
This has caused bonds to do what we would expect them to do in such an environment: go up.
This is what some bond traders refer to as the Bond Bull Market. But unlike an Equity Bull Market which is caused by economic growth, the Bond Bull Market has been caused, mainly, by falling interest rates.
Is a Bear Market Around the Corner?
So why it this a problem? Well, here’s why. Now that the economy is on the upswing, the Fed is raising interest rates.
So if interest rates drop and cause bond prices to go up, surely the opposite must happen when interest rates climb back up, right? What goes up must come down.
Remember Why You Own Bonds in the First Place
Remember: You are not a pure bond investor. You should only be really worried about the gyrations of the bond market if that’s all you invest in, but we’re not pure bond investors here like Bill Gross. We’re investing in a balanced, diversified manner in accordance with the principles of Modern Portfolio Theory. And in Modern Portfolio Theory, the main driver of your performance are equities. That’s the part that’s powering your investment gains. And the primary reason you own bonds is to reduce your portfolio volatility. Bonds are anti-correlated to equities, meaning that when equity markets plummet, bonds rise, and when equity markets soar, bonds fall.
That’s exactly what’s happening now.
There’s a time and a place to be panicking about the bond market, and this isn’t one of them. A “bad” reason for the bond yields to be spiking would be:
- Hyperinflation caused by a war
- Collapse in the value the US Dollar
- A hit to the credibility of the US government raising the possibility of a default on interest payments
None of those are even remotely true (well, maybe a hit to the credibility of the US government, but that’s another article).
The main reason that interest rates are creeping back up is because the economy is on solid footing. 200,000+ American jobs are being created each month and the US unemployment rate is the lowest it’s been in over 30 years.
This is not a bad reason to be raising interest rates. If the main reason the Fed is raising interest rates is because the economy is too strong, whatever losses you take on the bond part of your portfolio will be swamped by the increases on your equity side.
Remember, the primary job of bonds in your portfolio is to reduce your portfolio volatility. If your situation has changed and you decide you can tolerate more volatility, that’s the time to reduce your bond allocation and replace it with equity. But if your volatility tolerance hasn’t changed and you’re just spooked by the prospect of bonds going down, please do yourself a favor and log out of your Questrade account.
That being said, there are a few things you can do to reduce the impact of rising interest rates while still keeping that nice buffering effect. And that will be the topic of next Wednesday’s post.
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