By Tim D, Calkins, CFA

Interest rates have experienced significant volatility over the past few years given the pandemic, shut-downs, re-opening, additional waves of infection, global supply chain issues, and now, the Russian invasion of Ukraine.

Interest Rates on 10 Year Treasury Bond

Source: Bloomberg; Nottingham Advisors 2022

When market interest rates decline, bond prices tend to rise. For example, a 5-year Treasury bond with a 2% coupon (the amount of interest paid annually), trading at face value ($1,000), and yields 2%. If market rates decline to 1%, the bond’s price must rise to reduce the yield to the market level. This will result in a price higher than face value (the amount you receive when the bond matures), which will offset a portion of the coupon payment that you receive, lowering the bond’s yield to the current market rate. A bond portfolio’s value increases, as market interest rates decrease.

eTrade scale

Source: eTrade; https://us.etrade.com/knowledge/library/bonds-cds/bond-interest-rate-inflation

This move is magnified by the length of the average maturity/duration of the bonds. More duration results in larger price movements.

Interest rates plunged in early 2020 as the pandemic came into focus. The 10-year Treasury bond yield declined to ½ of 1% (50 basis points) at its lowest point. A yield that low clearly signals strong concerns about future economic growth, which makes sense in the middle of a pandemic, amid rolling economic shut-downs. Even with a cloudy economic outlook, this large decline in yields was a positive for the performance of bond portfolios. The longer the duration, the higher the return realized.

Bloomberg

Source: Bloomberg; Nottingham Advisors 2022

There is some symmetry in how bond prices move. In 2020, prices went up as interest rates went down. In 2021 and into 2022, prices reversed course and went down as interest rates have gone up.

eTrade scale

Source: eTrade; https://us.etrade.com/knowledge/library/bonds-cds/bond-interest-rate-inflation

A negative return can come as a surprise to bond investors. Bonds typically exhibit less price volatility than other investments, provide ballast within a portfolio when riskier assets decline in price and can go many years without producing a negative calendar year return. In almost 50 years of history, the Bloomberg Intermediate Government/Credit bond index has only recognized a handful of negative annual returns.

0325_blog_bonds_figure5-e1648559545869

Source: Bloomberg; Nottingham Advisors 2022

Even with a long history or providing relatively stable returns, bonds are not invulnerable. In a challenging rising interest rate environment, drawdowns are difficult to sidestep. With domestic inflation approaching double digits, and the Federal Reserve positioning itself to aggressively raise interest rates while reducing its Quantitative Easing (QE) program of buying significant amounts of Treasury bonds, fixed income investors face a difficult backdrop. Year to date, bonds have experienced one of their worst spates of performance in recent history, with the longest Duration portfolios being impacted the most.

0325_blog_bonds_figure6-e1648559603175

Source: Bloomberg; Nottingham Advisors 2022

There are some strategies that can be incorporated into portfolios to help reduce the negative impact of rising interest rates.

  • Reducing the Duration of bond portfolios during periods of rising rates provides some insulation, lessening the severity of a drawdown.
  • Floating-rate fixed income securities with minimal duration provide protection against the negative price impact created by rising interest rates.
  • Higher yielding bonds that produce more cash flow can also provide some cushion by allowing a portfolio to earn its way back from price declines at a faster rate than a lower yielding portfolio would be able to.
  • Positions that have been negatively impacted can be utilized for tax-loss swaps, offsetting gains/income and perhaps creating a carryforward to offset future taxes.

We are actively implementing these strategies when it makes sense, as we continue to navigate uncertainty and volatility in the fixed income markets. If you have questions about your fixed-income holdings or any elements of this letter we would be happy to discuss. We thank you for your trust in us and for your continued support!


For more information about Nottingham’s offerings, visit www.nottinghamadvisors.com or call 716-633-3800.

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