Inflation has been dominating the headlines and a concern among fixed-income investors. Stock investors generally benefit over the long term since companies pass higher prices to consumers, and increased profits eventually make it to their bottom lines. However, fixed income investors can get bitten by inflation.
U.S. Treasury bonds are usually safe in one sense — preserving your principal when held to maturity. Your return might not outpace inflation, but you likely won’t lose your principal. When held to maturity, a bond should always give you a positive return. Bonds are appropriate when your goal is principal protection — i.e., money you need within the next 10 years. However, a 3.12 % interest rate on a 10-year U.S. Treasury bond is not the most appealing when inflation is at 8.5 %.
Furthermore, we’re also experiencing an inverted yield curve where short-term interest rates exceed long-term rates. When the 10-year Treasury interest rate is less than the two-year Treasury, it indicates that near-term is riskier than the long term. In general, the Federal Reserve has a lot of influence over short-term interest rates, as many of them are tied to the Federal Funds Rate, the rate at which banks lend on an overnight basis. The Federal Reserve has also made it very clear they intend to continue raising rates throughout 2022, so the increase in short-term bonds should be no surprise.
When you sell your bonds during a period of rising interest rates, you need to be concerned about a real loss. As interest rates rise, newly issued bonds generally carry a higher yield. If you want to sell the bond you have been holding, you will likely have to sell it for less than it cost you because the price falls to match higher market yields. This is interest rate risk.
Current bond investors may be locked into very low yields. A year ago, the 10-year Treasury carried a 1.29 % interest rate. However, the interest rate risk can be greater for bond fund investors. Those who invest in bond funds generally miss out on two key characteristics that owning a bond provide: a fixed yield and a contractual maturity date. The yield on a bond fund “floats” with market yields and portfolio management. As rates fluctuate, yields and prices on bond funds do the same.
When you own a pool of bonds that are constantly maturing, the value of the portfolio is based on the market value of the bonds in the portfolio at any given time. A bond fund portfolio manager rarely holds the underlying bonds to maturity. Therefore, bond funds generally have no guarantee of a specific maturity value on a specific maturity date. If interest rates increase quickly, you could get a negative return on your bond fund investment. Bond prices could fall enough to wipe out any dividend the bond fund may be paying.
If you must invest in bonds during a period of rising interest rates, I recommend keeping maturities short in the one- to three-year range. Longer maturity bonds, such as 10-year or 30-year bonds, are more sensitive to interest rate changes. 2022 has been a particularly difficult year for bond investors, but holding individual bonds to maturity should at least give you the solace of knowing the future cash flows you can expect.