What a difference a few simple words can make. In early May, the Federal Reserve issued a press release that included the short phrase, “The Committee is prepared to increase or reduce the pace of purchases.” With that, the bond market began a dive and fell almost 5% in just 10 short weeks.
It’s now clear the Fed plans to slink away from the money-printing business. They plan to delicately dial down the drip of stimulants being fed to the markets. They plan to slowly taper down their rate of asset purchases to nothing within a year. At least that’s their plan.
Well, it’s now also obvious bond investors don’t like the Fed’s big plans, no matter how slow, delicate and slinking the design. Bond investors tend to flip to the end of the book very, very quickly. The end of money-printing, to them, is the Fed’s first step toward ultimately raising interest rates. Signaling a rise in interest rates is like flashing red in front of a bull.
Experience shows that nothing quite gets the attention of investors more than losses in their bond portfolios. They just aren't accustomed to it. When it does happen — and this won't be the last time — it offers a great opportunity to explain how bonds work and how to think about them.
There are three concepts to grasp. And, with these, you’ll be way ahead of others.
Like gravity’s effect on the physical world, bonds are affected by a type of financial gravity in the form of interest rates. When interest rates rise, bond prices fall. When interest rates drop, bond prices rise.
First, the more interest rates change, the greater the effect it has on the value of bonds. It is all based on math. If new investors now demand more return on their money than you once willingly accepted, your particular bond investment — with the interest it pays to you contractually set in stone — must naturally fall in price. What else would entice someone to buy your low interest bond?
Second, the farther in the future an investor is slated to get his principal back, the greater the effect interest rate changes have on the value of bonds. Imagine you own a bond with a low, locked-in interest rate for a long time. If interest rates change and investors begin to demand higher returns on their money, selling your bond is going to be difficult without offering a discount. Who would want to be stuck with the long-term deal you struck a while back?
Third -- and this is truly important -- if you plan to hold your bonds until maturity and if you receive your promised interest and principal as planned, you will earn exactly what you once expected. Not a dime more or a dime less.
Jason P. Tank is a Chartered Financial Analyst and co-owner of Front Street Wealth Management, a fee-only wealth advisory firm located in Traverse City. He encourages questions and comments about future columns. Contact him at (231) 947-3775, by email at Jason@FrontStreet.com and at www.FrontStreet.com