The bond market is off to one of its worst quarterly performances` in close to 40 years as it’s now clear the inflationary is not “transitory” which has challenged the Federal Reserve’s traditional models and forecasts. On March 16th, the Federal Reserve raised overnights rates a range of 25 to 50 basis points for the first time since late 2018. An additional 9 increases are now priced into the market looking forward 1 year out. The March 2023 Federal Funds futures contract is now at 2.50%.
Rate hikes are a common tool the Federal Reserve utilizes to control inflation. Historically, inflation is the result of an overheating economy caused by consumer leverage. Consumers have access to cheap money which increases demand for goods and services. The Federal Reserve uses interest rates as one of their tools to slow down economic growth that in their opinion is unsustainable. The Fed increases the cost of overnight loans to commercial banks who in turn pass along the increase to their clients making credit card, auto and mortgage loans more expensive. The increased cost will hopefully slow down pace of spending. The committee’s long-term target to sustained annual inflationary is about 2%. Year on year inflation is running at a staggering 7.90%. The graph illustrates the recent dramatic increase.
Those impacted most by higher rates are consumers who have a debt burden and holders of fixed rate bonds. Beneficiaries are investors who have cash to invest in fixed income instruments.
It is important to remember the relationship of bond prices and interest rates. As interest rates climb higher, the valuation of fixed rate bonds drift lower. How much the market price drops is highly dependent on the bond’s maturity. Bond math and bond pricing is relatively simple, it’s all about an opportunity cost gained or lost and discounting cash flows.
As an example, let’s assume you own a $100,000 of a 10-year 3% bond that you paid $100,000 for in December in 2021. Based on anticipated Federal Reserve increases a new 10-year bond rate is now at 4% today, what is your 3% bond worth?
Present value the difference between 4% and 3% over the next 9.75 year (March 2022 to December 2031). Take result and subtract it from $100,000. The present value of the opportunity cost of earning 1% less for the next 9.75 years equals about 8% today. Now we know a $92,000 of a 3% bond that will be worth $100,000 at maturity, is equal to $100,000 of a 4% bond with the identical maturity. This is how bonds are valued on a statement. As you can see the longer time to the maturity, the greater the price impact from interest rate changes. It is important to remember that bond pricing due to interest rate movements represent opportunity gains or losses. The holder of the 3% will continue to get a 3% payment on the $100,000 invested until the bond matures. The difference between the current market of 4% and the owners 3% bonds is reflected on a statement as UNREALIZED gains or losses.
If one owns bonds in a portfolio, it is important to understand bond valuation. It is necessary to place every bond on an equal playing field as individual bonds are traded 24 hours a day. It is also paramount to remember that bonds (unlike stocks) are required to pay interest and return principal at maturity. In the example above, the bond that now has a market value of $92,000 will return $100,000 when the bond matures. Assuming interest rates are a constant 4% until the maturity the bond you can see how the bond will increase in value every year.
As a final note the Federal Reserve is data dependent. Every meeting is live and even though there are 8 additional moves priced in over the next 12 months there is no guarantee the rate hikes will come to fruition. Conversely, if the Fed could take an even more aggressive approach the market could price added hikes.
As always please reach out if you have any questions.
Material discussed is meant for general informational purposes only and is not to be construed as tax, legal, or investment advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon only when coordinated with individual professional advice. This material contains the current opinions of the author but not necessarily those of Guardian or its subsidiaries and such opinions are subject to change without notice. Charts are for illustrative purposes and are not intended to suggest a particular course of action or represent the performance of any financial product or security. Investing in the bond market is subject to certain risks including market, interest rate, issuer, credit, and inflation risk. Past performance is not a guarantee of future results.
This material is intended for general use. By providing this content Park Avenue Securities LLC and your financial representative are not undertaking to provide investment advice or make a recommendation for a specific individual or situation, or to otherwise act in a fiduciary capacity.
Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS). OSJ: 2111 RT 34 SOUTH, WALL NJ, 07719, 732-5284800. Securities products and advisory services offered through PAS, member FINRA, SIPC. Financial Representative of The Guardian Life Insurance Company of America® (Guardian), New York, NY. PAS is a wholly owned subsidiary of Guardian. C & A Financial Group, LLC is not an affiliate or subsidiary of PAS or Guardian. 2022-135724 Exp. 3/23
Sources: Bloomberg and the Federal Reserve
Jeremy has been in the financial advisory business since 2005 after graduating from Fordham University’s School of Business. He joined Tomoro as a managing partner in 2014. During his tenure, Jeremy has consistently excelled as an advisor in both the personal household and business planning arena. As a managing partner, Jeremy also serves as a mentor to all associates and is hands-on in supporting Tomoro’s growth planning. He has completed various curriculums and certifications, such as New York University’s graduate studies in financial planning, is a Certified Exit Planning professional, and Investment Advisor Representative. He and his family reside in Colts Neck, NJ.
Registered Representative and Financial Advisor of Park Avenue Securities and Financial Representative of Guardian, AR insurance license #8401385 CA insurance license #0F94382
The S&P 500 Index is a market index generally considered representative of the stock market as a whole. The Index focuses on the large-cap segment of the U.S. equities market. The Hang Seng Index (HSI) is a market-capitalization-weighted stock market Index in Hong Kong. It is used to record and monitor daily changes of the largest companies of the Hong Kong stock market and is the main indicator of the overall market performance in Hong Kong.
Indices are unmanaged, and one cannot invest directly in an index. Past performance is not a guarantee of future results. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest rate, issuer, credit, and inflation risk. Equities may decline in value due to both real and perceived general market, economic, and industry conditions.
Statistics sources from Central Bank Rates and Bloomberg.