By Evan R. Guido
It’s been a long time since the Fed has had to put out an inflation fire as big as this one. Fixed income investors, you might be in for some surprises. Whether you invest in bond funds, marketable certificates of deposit, municipals, corporate bonds or Treasuries, you should know how interest rates affect bond prices.
The only two things that are “fixed” in fixed income are the interest and the principal bondholders receive at maturity. The market price of fixed income will depend on its creditworthiness, interest rate and how much time remains until the bond pays principal.
Their market prices primarily move because interest rates change. If you own a bond paying 5% a year and interest rates increase, new bonds will pay higher yields than yours. The price of your bond must fall for buyers to accept that lower interest payment, otherwise investors will only buy new bonds that pay at the higher rate. Bonds also trade on what investors expect interest rates to be in the future, which is why bond buyers pay so much attention to the Federal Reserve.
Fixed income mutual funds are trickier because there is no maturity for a bond fund and active managers frequently trade bonds continuously for even the slightest perceived advantages.
Just like Olympic runners, the difference between a top-rated bond mutual fund and one that’s middle of the pack may come down to a miniscule difference in annual return.
It’s smart to understand just how much interest rate risk your investments have. A general rule is that the longer the maturity and the lower the interest payment, the more the price can fluctuate, both up and down. Zero coupon bonds that mature in 20 years will fluctuate more than a 6% bond that matures in three weeks.
So, if you expect interest rates will go higher than what the market thinks, you stay with short-term fixed income or cash. If you think rates will go lower than everyone else expects, then you want to lock in those long-term bonds.
Happily, we can get more precise. There’s a number that can tell us how much a bond or even a bond fund’s price can move, and it’s usually easy to find. Modified duration factors in interest rates, call or put features and maturity. Because short-term bond funds have short maturities, they have low modified durations.
A fund or bond’s modified duration is how much, in percent, the fund’s price will adjust for an unexpected 1% shift in interest rates. For example, if you own a bond with a modified duration of six and the Fed drops rates suddenly by 1%, the price of your bond should increase by 6. Remember, if interest rates go up, the price goes down.
There are other reasons bond prices can move, too. Companies with growing and predictable cash flow and low debt are more creditworthy than startups burning cash. As companies’ financial strength improves, so will their bond prices, because they are safer investments, and we’ll discuss creditworthiness next week.
Evan R. Guido is the founder of Aksala Wealth Advisors LLC, a 2018 Forbes Next-Gen Advisors List Member, and Financial Professional at Avantax Investment ServicesSM. Evan heads a team of retirement transition strategists for clients who consider themselves the “Millionaire Next Door.” He can be reached at 941-500-5122 or firstname.lastname@example.org. Read more of his insights at heraldtribune.com/business. Securities offered through Avantax Investment ServicesSM, member FINRA, SIPC. Investment advisory services offered through Avantax Advisory ServicesSM, insurance services offered through an Avantax affiliated insurance agency. 8225 Natures Way, Suite 119, Lakewood Ranch, FL 34202.