Fiduciary John Mateyko, APMA®, WMCP™, RICP® On Bonds, Inflation, And A Potential Recession
The talk of the market recently has been the combination of economic uncertainty and rising interest rates.
As a result of this general chatter, I’ve had a couple of clients reach out with the same, very astute question: Typically, these clients have heard bonds are a good investment during a recession. But, they ask, is that still true amid rising interest rates, which can send bond prices lower?
The answer – as is usually the case – is more complicated than a simple yes or no. With that in mind, I thought I would send over some guidance on this subject in case you have wondered (or are now wondering) the same thing.
First, however, let’s start with the basics:
What Bonds Are - When a government or corporate entity needs capital, they sell bonds. In return, investors receive interest payments in addition to their invested principal.
What “Bond Prices” Are - This is the price of the bond or its face value. In general, as interest rates increase, bond prices decrease.
Why Bond Prices Decrease When Rates Rise - It boils down to simple supply and demand. Let’s say an investor buys a corporate bond for $1,000 at a fixed interest rate yield of 5% annually. After the investor buys this bond, interest rates rise in the overall market over the next couple of months. Since interest rates are higher now, new bonds that come out on the market will pay a higher yield, say 5.5% now versus the 5% this investor is getting.
Therefore, the price of the bond our investor bought decreases–in our example, from $1,000 to $980. This decrease is because an investor could now buy a newly issued and nearly identical bond that yields 5.5% at this time for that $1,000.
Whether Bonds Can Still Be Good Investments - Fixed-income investments certainly have their place as part of a diversified portfolio. That said, in a situation like we’re currently in, bonds are not always profitable, as you can see in the example above. Some bonds, however, are designed to work better in a rising interest rate environment. I’ve provided a list of them below.
Treasury Inflation Protected Securities (TIPS): These are U.S. Treasury securities where the value of the principal is indexed to the inflation rate via the Consumer Price Index (CPI).
Featuring terms of 5, 10, or 30 years, TIPS pay a fixed interest rate every six months until they mature. The principal of a TIPS fluctuates over its term based on changes in inflation.
At maturity, if the principal is higher than the original principal amount, the investor gets the higher principal amount. If it is lower, the investor receives the original principal amount.
Since the principal of a TIPS increases as inflation rises, they can be an option for investors seeking fixed-income products in a rising inflationary environment.
They’re available in increments of $100 up to $10,000,000.
Series I Savings Bonds: These savings bonds earn interest monthly, and interest is compounded semiannually. So at each six-month interval, the bond’s interest rate is added to the new principal value.
Every six months (on May 1 and November 1), the inflation rate is computed based on CPI-U data. The resulting inflation rate is then applied to all outstanding I-bonds for the next six months. The result is a savings bond designed to keep up with inflation.
Redemption periods for I bonds begin after 12 months, and they can earn interest for up to 30 years. Electronic series I bonds are available in any amount of $25 to a maximum of $10,000 per Social Security number per calendar year.
Fixed-Income Mutual Funds: For investors looking to diversify their fixed-income strategies, opting for professionally managed mutual funds can help provide exposure to hundreds or even thousands of bonds in a single product.
In addition to professional management, curating an allocation among several different mutual funds can diversify bond types, credit risk, maturity periods, and yields.
Short-Term vs. Longer-Term Bonds: Historically, as rising inflation leads to higher interest rates, short-term bonds have been more resilient than their longer-term counterparts. 2022 has been different, though, as short-dated interest rates have risen faster than their longer-term counterparts. This means that short-term bonds offer a better interest rate right now; unfortunately, it also means we currently have an inverted yield curve, which is a key recession indicator.
Another consideration for would-be investors: short-term bonds offer the flexibility of quicker maturities so that investors can reinvest their proceeds more frequently at higher interest rates (should rates rise) or in different assets.
That said, while locking in higher yields in the current marketplace has its merits, a full analysis by a professional is often warranted to determine break-even points and suitability for each investor.
Wrapping It Up
We can only cover so much in one article, here's a link to pick up some nuggets of bond knowledge.
The current landscape holds different opportunities than were previously available in a non-inflationary environment. Ultimately, though, there is no one-size-fits-all approach or answer to fixed income allocation within a portfolio.
About John Mateyko, APMA®, WMCP™, RICP®
In the dynamic world of finance, John Mateyko's expertise sheds light on the growing inclination towards customized retirement strategies. He, through his firm IDEX Financial, is spearheading a novel perspective on retirement planning. His methodology is not solely focused on figures but also takes into account the distinct scenarios, aspirations, and wishes of each individual. John Mateyko foresees a future where personalized finance planning empowers people to step into their retirement confidently, knowing their strategies are designed to meet their particular needs.
In this period of progressively personalized finance planning, John Matekyo is dedicated to employing his knowledge and resolve to assist those who seek to ensure their financial security while also enjoying a life enriched with experiences that transcend financial wealth.
About IDEX Financial
IDEX Financial, part of the PeachCap Family Office, is devoted to a neutral methodology with the aim of identifying market opportunities. They strongly emphasize on education, viewing it as a potent instrument that can navigate their clients towards financial success. At IDEX Financial, they promote a proactive stance. They endeavor to put into action tactics that will genuinely improve their clients’ financial status. They treasure establishing lasting relationships and provide advice to clients through various financial shifts in their lives.
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