With interest rates at historic lows and inflationary pressures mounting, bondholders owning bonds with long maturities may need to consider shortening those maturities. If (when) interest rates begin to rise, bond prices will decline. More importantly bonds with longer maturities will tend to decline much more than those with shorter maturities. There are certain characteristics of bonds, however, that make the impact of rising interest rates more or less dramatic, in terms of price declines.
The Federal Reserve (The Fed) has held short rates at basically zero percent for over two years, going back to December 16, 2008. In addition, the Fed and the Treasury Department have been doing all sorts of things to stimulate the economy, such as quantitative easing – buying securities like treasuries and mortgage-backed bonds to pump additional cash into the economy. The theory behind all of this is that more cash in the economy with low rates will push consumers and businesses to spend more money (because there is more of it around, so it is (theoretically again) easier to come by.
Lower interest rates definitely make the cost of borrowing lower, at least for those individuals and businesses that can qualify for loans. However, the problem with all of this “easy money” is that it can drive inflation. In fact, that is exactly what we are starting to see take place. Commodity Prices have been at very elevated levels for many months now. Although many companies that use commodities as inputs or raw materials in the production of goods are able to hedge some, or in some cases all of the risk of commodity price increases away, after a while, the contracts they are using for their hedges expire. This means that they are no longer able to hedge as much, or possibly any, of the price increases away.
Once commodity prices stay elevated for extended periods, producers experience rising input costs, and therefore must either pass-on those costs, or part of those costs to the consumer, or their profit margins get squeezed. Higher prices to the consumer mean that consumers can and will buy less. They buy less partially because they have less buying power since prices have increased, and partly because they don’t feel good about the economy and prices increasing. Businesses therefore lose sales, which means their revenues and profits will be lower.
If a company is unable to pass-on the cost increase of their inputs, their profits get squeezed, making their stock value decrease, their ability to borrow erode, and making their internally-generated cash available for research and development, expansion, hiring, purchasing other companies, etc., decrease.
To combat the negative impacts to the economy of inflation, the Fed will be forced to begin raising rates, and may even need to reduce the money supply by backing out of some of the quantitative easing they have undertaken recently. Once rates begin to rise, there can be, and very likely will be, negative consequences to the economy and for investors. If the Fed can raise rates gradually, in a controlled and well-planned manner, it is certainly possible that the economy can continue to grow at a modest, but acceptable pace. That will certainly be the game plan of the Fed. However, if the Fed waits too long before beginning to raise rates, or if inflation gets too far out of control, the Fed will be forced to raise rates more quickly than they would like to, and this could have devastating consequences for the economy, businesses, consumers and investors.
One of those unfortunate and costly consequences will be the negative impact on bond prices. Bond prices generally move in the opposite direction to interest rates—if rates go up, bond prices go down, and vice-versa. One of the positive outcomes of the weak economy and the reduction of interest rates over the past few years has been the positive impact that falling rates has had on bond prices. In fact, many bond investors and bond fund managers have performed exceptionally well during this time. Unfortunately, the majority of positive performance has come from those falling rates, and not because of the expertise of the manager (at least in most cases).
Now that rates have bottomed, the economy appears to be recovering, and inflation is heating up, we should see rates begin to move higher across the yield curve—the spectrum of interest rates based on the maturities of the various types of bonds, such as treasuries. When we talk about the yield curve, we are typically discussing the U.S. treasuries yield curve. The treasury yield curve starts at zero, moves up to 0.5% at the two-year maturity, to about 1.8% at the five-year, to 3.2% at the ten-year, and to 4.3% at the thirty-year. The curve is relatively flat at the moment, meaning the difference between the short end and the long end is not all that large.
What tends to happen when inflation heats up is that the longer end of the curve—the part that the Fed cannot manipulate, will begin to move up in yield, reflecting the higher perceived risk in the economy. In order for this to happen, bond prices must fall (remember that inverse relationship—bond price moves the opposite way as interest rates). The curve will tend to steepen, meaning that the difference or spread between short maturities and long maturities will increase, sometimes dramatically if inflation is strong. This steepening will tend to pull the short end of the curve up, even if the Fed doesn’t change the Fed Funds rate. (Remember that the Fed can only set a target rate. The market actually determines where rates are at any point in time.)
As the curve both steepens, and shifts higher, bond prices move down across maturities. However, longer maturities will tend to experience much greater price declines, since the change in longer rates will typically be much more pronounced. There are several reasons for this difference between the impact on bonds with short maturities and those with long maturities. First, because owners of long maturity bonds are stuck in them for a longer period of time, their risk is greater, so they are more likely to want to get out if things start to go south as compared with bondholders in shorter maturity bonds. Those in the shorter maturities can wait it out, holding their bonds to maturity if need be, since the time to maturity is relatively short. Those in the thirty-year bonds, have to wait for thirty years to get out. Psychologically this is a big negative, and will tend to push more of those long maturity holders to want to sell. More selling means a bigger price decline.
Another interesting driver for long maturity bond price declines in a rising interest rate environment is duration. Duration is the weighted average of the times until the fixed cash flows from the bond are received. Duration also measures the price sensitivity to yield, or the percentage change in price for a parallel shift in yields. Without making your eyes cross with a bunch of math, the point of duration is taking the weighted average of all of the cash flows that the owner of the bond will receive during the entire life of the bond. The easiest way to think of duration is to look at a zero coupon bond. No cash flows are received on a zero coupon bond until it matures, at which time all interest earned during the life of the bond, plus the principal is returned to the investor. A zero coupon bond, for a given maturity, has the longest duration because all cash flows are received at maturity—at the very end of the bond’s life. Because, in general, longer maturity bonds have longer durations, they are impacted more significantly in price when rates move up or down.
If you agree with me that interest rates have only one direction to move and that is up, and that rates will begin to move up sooner rather than later, then if you are a bondholder, you may want to consider whether you should hold long maturity bonds. There are many reasons why investors own bonds, or any investment for that matter. Each investor must make their own decisions based on their own needs. However, I believe that long maturity bonds will suffer as rates rise and will suffer much more than short maturity bonds. Anyone owning long maturity bonds should at least consider this when making portfolio decisions.