Think You Can’t Make (Or Lose) Money in Bonds? Think Again

Fixed-income investors finally had a good day yesterday. Yields, which are the same thing as market interest rates, were down sharply across the yield curve. When yields decline, bond prices go up. And it’s been quite a while since yields have made such a dramatic one-day move downward. So let’s take a look at what can happen to the price of a bond when yields drop so quickly.

Early on Wednesday morning, the yield on the 10-year Treasury bond hit a 12+ year high of about 4.0%, which was up from a low of about 0.5% in mid-2020. We’ve written ad nauseum about the many reasons behind the increase in interest rates over the past couple of years, but for purposes of this Market Commentary let’s just say investors are worried about inflation and Fed interest-rate hikes. At about 6:00 am EST on Wednesday, those fears were (likely temporarily) interrupted by a specific news item coming from the Bank of England (again, beyond the scope of this Market Commentary). When that news hit the tape, investors started buying bonds hand over fist, taking the yield on the 10-year Treasury to just 3.71% by Wednesday afternoon. This 0.29% decline in yield in such a short period of time is fairly anomalous, but it does happen. 

Let’s assume we had the perfect foresight to buy a 10-year Treasury bond early on Wednesday morning when the yield was 4.0%. Let’s also assume the bond we bought pays a 2.75% coupon and matures on September 28, 2032. The table below shows the purchase price ($897.80), which is determined by calculating the present value of the fixed cash flows (coupons and principal) we expect to receive over the next 10 years using a discount rate of 4.0% (the market yield at the time of purchase). In other words, when you buy a 10-year bond you are buying 20 bi-annual coupon payments along with a principal payment, normally $1,000, to be paid at the end of 10 years. If the coupon on the bond, in this case 2.75%, is not equal to the current market yield, the market price for the bond will be higher or lower than par (or face) value. The bond we are purchasing only pays a coupon of 2.75% instead of the market rate of 4.0%, so the value (price) of the bond will be below the par (or face) value of $1,000. Capisce?

Now, as the market yield fell during the course of the day on Wednesday, the value of the bond we purchased at 6:00 am increased in value. Why? Because when market interest rates decline, the value of a fixed stream of cash flows to be received in the future increases, and vice versa. The chart below shows the new prices for our bond given different changes in market yields. For instance, if the market yield for a 10-year duration Treasury bond had increased by 0.50% on Wednesday instead of falling by 0.31%, the value (and price) of our bond would have declined 4.2% to $860.32 instead of rising 2.5% to $920.40. Those may not sound like big moves in price, but the 2.5% increase on Wednesday represents more than 5x the amount of annual interest we could have earned two years ago when the 10-year yield was around 0.5%. 

As it turns out, market yields are rebounding a bit today. Therefore, we would have given back some of our 2.5% gain if we continued to hold the bond. But I think it’s safe to say that increased volatility (and reduced liquidity) notwithstanding, more and more long-term investors are starting to look at longer-term Treasury bonds as attractive sources of income again. Following many years of artificially suppressed interest rates, it’s nice to be able to at least consider longer-term Treasuries as part of a high-quality, diversified bond portfolio. Finally, I would note that the same type of analysis can be done for other types of bonds, like municipal bonds, corporates, or agencies. All bonds are priced off of the “risk-free” rate, which is the rate paid on US Treasuries. And so as yields have become significantly more attractive on Treasuries, they have also become more attractive for other types of bonds. Cautionary note: now is not the time, in our view, to speculate for extra yield by buying junk bonds simply because the yields are higher. A slowing economic environment is the time to ensure that the credit quality of your bonds is rock-solid. The conservative route is to stick with investment-grade credits that have been thoroughly researched and vetted, especially now that yields for even the safest bonds are as high as they’ve been in many years.