Have bond prices already factored in interest rate hikes or will they lose further value when interest rates do rise?

I hope you’re going well and welcome to Finance and Fury. This week we have a question from a listener, David, in relation to bonds. The question is “Are the predicted interest rate hikes already factored into the price of the bond market? Or do you think we’ll see them lose value when the interest rates do rise?”

1. Great question – With all major bond indices in the red – bond pricing has already been in decline – even prior to interest rate increases and since 1981, the Aggregate Bond index has only ended a year with a negative total return four times – This year, all major bond indices are in the red – Corporate and Treasury and the aggregate – so will things get worse once interest rates increase further, or are the price declines already priced into markets

Go Through the theory – How the pricing of bonds works, and what happens in theory when interest rates rise?

2. What is happening to bonds and why are they losing value? 2022 has not been a good year for the bond market – this is for several reasons, most of which have been previously covered so I won’t do a deep dive into it – but give a general summary
   1. First you have Inflation – this has been increasing – partially due to fiscal stimulus which put cash in people’s pockets but mostly due to a shattered global supply chain – where the decline in supply has been unable to keep pace with demand
      1. For bonds – When inflation is high the real yield on a bond when inflation-adjusted can be negative
         1. If a bond had a yield of 3% and inflation is 4% = real returns of -1%
      2. Looking at many US 10-year bonds, the real yields are -4% – understandably this has caused some investors to rethink their investment strategy as it relates to fixed income – bonds are meant to be a defensive investment to avoid losing money – so who would hold a bond if you are going to lose money in real term – this has led to capital flight from this asset class – putting downwards pressure on demand and hence prices
   2. Secondly, you have Monetary policy – The Federal Reserve and other Central Banks are in the process of putting an end to easy-money policies – in the process they are going to raise interest rates
      1. When interest rates rise – investors in the primary market earn higher coupons on newly issued bonds – When bonds are sold to investors – their income payments are normally tied to the current cash rate plus a risk premium
      2. This generally means outstanding bonds that have been issued in a low interest rate environment are worth less to those issued in a higher interest environment – basically any bond issued over the last 2+ years won’t pay the same income as a bond that may be issued in say 12 months’ time
         1. Therefore – the market has been pricing in multiple interest rate hikes all year, which is reflected in total returns, which is a major contributing factor to the existing bond market declining in price
      3. This brings up the balancing act between inflation and interest rates – The Federal Reserve has indicated that they are planning to raise interest rates aggressively to combat inflation. Getting inflation under control quickly without damaging the economy is not a simple task – I would say that it is almost impossible in a world that is so debt heavy – but the very fact that most of the inflationary pressures are coming from supply issues, how will increasing interest rates help to reduce fuel prices, or food costs – in reality it won’t – hence it will mostly fall on consumers to cover higher debt financing costs and have less available cashflow to afford the already expensive costs of everyday living – this point aside – looking purely at the debt markets in the form of bonds –
         1. When investors have concerns about the economic outlook, it’s not just a matter of selling shares and buying bonds or vice versa. Shares are much better than bonds for combatting inflation over time due to getting capital growth – a bond only gets its original value back at maturity – but when there’s a risk-off sentiment, bonds outperform – Right now – Bonds are outperforming stocks by being less negative on a relative basis – both US shares and Bonds have lost value, just bonds haven’t lost as much

Why prices are affected by interest rates – and when do this prices changes take effect? Let’s look at an example of a Bond

1. Let’s say that you are a defensive investor and you were to purchase a bond that was issued by the government with a face value of $100 – meaning that you purchase this for $100 when it is issued – and then that this bond matures in 10 years’ time, where you will get your original $100 back.
2. The bond has a 1% coupon rate, which means that it pays you $1 per year – remember that this coupon rate is often tied into the current cash rate plus a risk premium – if it is a government bond – low risk of default, so if the cash rate is 0.75% then the bond may pay 1% coupons – For some bonds this may be a 6 monthly coupon payment, meaning you get $0.50 every 6 months
3. Now – time goes on and it is one year into the future – By this time interest rates have increased to 3% – where newly issues bonds have a coupon payment of 3% on them
   1. Because buyers can now purchase a $100 bond with a $3 coupon payment, your $1 coupon payment doesn’t look so great – for a 10-year bond someone could purchase a newly issued bond and get $30 in income return over the next 10 years – whilst your bond has 9 years left until it matures, but is only paying $1 p.a. = $9 in total – who would want to buy this bond?
   2. If you want to sell your bonds – you need to incentivise a buyer – therefore you’ll have to sell your bond at a discount.
   3. The price of a bond is worked out by taking the sum of all remaining coupon payments and discounting these by time by the interest rate, then adding the face value discounted by the interest rate to the power of the time until maturity
4. How Much Will Bonds Fall When Interest Rates Rise?
   1. Due to the pricing mechanics – it can be rather complex to figure out how much the price of a bond falls when interest rates rise – due to the number of variables in play:
      1. The current interest rates, how many coupon or interest payments you expect to receive until it matures, how much each bond’s coupon payment is, The future value of the bond (face value)
   2. For example, if you purchased a $100 Bond where the cash rate and the coupon rate ate 3%, which had 18 coupon payments remaining of $1.5 each (being 9 years in the future assuming 2 coupon payments per year)
      95. If interest rates were to increase to 4% – the price of this bond would drop to $95.50
      96. If interest rates were to increase to 5% – the price of this bond would drop to $85.65

• If interest rates were to increase to 6% – the price of this bond would drop to $79.37

1. Yields and durations – The yield off a bond is not the coupon payment solely, but your total return from purchasing a bond and holding this until its maturity – say you buy a bond for $80 and in 9 years you are going to get $100 back at maturity, plus the coupon payment of 3% p.a. = your yield is close to the market value for newly issued bonds at 6% p.a. as you are purchasing this asset at a discount and get a greater price back than you paid for the bond at maturity

5. But when does this happen – before or after interest rates go up? It is a mix of both in reality – What markets expect is priced into markets based around the probability in the time period it is expected –
   1. If you and the market (i.e. ever other investor out there) know that it is a 100% that something will happen – that event will be priced into the market before it happens
   2. Say for Company A – it is expected to lose all of its revenue and default on its debts – but this is sitting at a 80% chance – this means that this company will still be trading – it would have lost most of its value – but that 20% that the company doesn’t default is a chance – which presents an opportunity for risk takers to buy in – if the company does default – most of the losses occurred before this event played out – as it was expected that this would play out
   3. This is the same for debt markets – Russian Government debt dropped 80% in value in most cases before the news of a potential default was announced –
6. Looking at the US debt markets – Being the first western central bank to raise interest rates since 2018 – Fed raised their funds rate on 16^th March this year – raised by 0.25% or 25 basis points to 0.5%
   1. What happened to the US Bonds or treasury notes? Yields 1.77% at 1 March – 2.18% by 16^th march – then after the announcement increased to 2.49%
      1. These yields as they increase on existing issued debt instruments means that the price has dropped
   2. Was sitting at 1.19% yield in August 2021 – the thing with pricing of bonds is that it all comes down to the yields that you can get off the asset – bonds all have different maturities – one bond may have been issued in 2000 with a 30 year maturity paying a 5% coupon, and another bond may have been issued in 2020 with a 10 year maturity with a 1% coupon payment – both will mature on the same day – but both will also be trading at the same yield – as the older bond will be trading at a higher price than the recently issued bond
   3. Take two US bonds maturing in November 2028 – both were issued at $100 face value – one has a coupon payment of $5.25 whilst the other has $1.5 –
      116. The price of the first bond is $116.12 whilst the latter is $93.12 – but both bonds have a yield of 2.57% – as you will get $100 back in both situations – so the higher income is negated by the loss of the $16.12 over the next 6 years and 5 months
   4. Coming back to the original point – when the drops in pricing occur –
      1. Bonds tend to drop the most in anticipation of an event – but they also continue to drop as the event plays out – it is due to timing and the possibility of something occurring ahead of schedule
         1. The more they drop is due to higher durations – not all bonds will suffer the same price declines from increasing interest rates
         2. If a bond is meant to mature next month – you will see barely any price movement – as you are going to get back to the face value next month anyone – but if the maturity is in 20 years, $100 then is not worth $100 today, so you want to see a lower price point if inflation is going to be high and interest rates are going to rise
      2. Everyone knew that rates would go up at some point –
         1. It was speculated that interest rates would rise in the markets this year – but it was anyone’s guess as to when this was actually going to occur
         2. Price movements before = looking at the prices of US bonds – and rather than focus on one, we will look a the yields for bonds maturing which gives a general guide to price movements
            1. From August 2021 to the start of March – the yield rose by 48% – which doesn’t mean prices dropped by 48%, but the returns of those bonds when discounted for the income returns did – which is a heavy decline
            2. Then from the 1^st of March to the 16^th of march – just before the announcement – the yield rose by a further 23% – meaning the prices dropped further – so from the 1^st of August 2021 to 1^st of March 2022 – the yield curve rose by around 83%
         3. Price movements after = yield went from 2.18% to 2.49% – so an increase of 14% – which is still a large increase, but in relation to a 25 basis point increase, the majority of the pricing into the market occurred before the announcement
            1. From here – many of the interest rate increases have been priced in partially – the thing that is unknown is the when – when these prices increases will materialise
         4. Disclosure – The examples discussed in this episode are for illustration purposes only. Both past performance and yields are not reliable indicators of current and future results – so whilst it can be inferred that if interest rates do rise from here further, some further losses can be incurred – this isn’t a given as most of this may already be priced into the market

In next weeks episode – we will look at the second part to David’s question – that is the allocation of funds to defensive assets compared to holding this in the bank – really interesting question that I have been considering for the past two years or so when it comes to clients asset allocations since cash provides nil interest rate returns –

Does it make any sense to invest in defensive funds at all? Or just keep these funds in the bank or offsetting debts.