Interest rates have an impact on just about every part of our financial lives. And when they move up as quickly as they have in 2022, it causes some major changes.
In this week’s podcast, Tom, Tim, Brendan and Casey discuss the impact interest rates have on bond prices. They share some numbers to show that if your bond investment’s time horizon is longer than the bond funds’, higher interest rates REALLY ARE of benefit to you.
Tune in to hear the guys break it all down!
Show Notes
Rubin J Miller CFA – Bond Prices thread
The Latest on the Stock Market, Interest Rates and the Economy – Mullooly Asset Podcast
Making Sense of the Latest Move in Interest Rates – Full Transcript
**Click here for a full downloadable PDF version of this transcript**
Casey Mullooly: Hello, and welcome back to the Mullooly Asset Podcast. This is your host, Casey Mullooly. And guess what? We’re back with all four of the guys again this week. Brendan, Tom, and Tim are back around the table. I went in the opposite direction last time, because no one is more or less important on this podcast. All right, guys?
Brendan: Wow. Thanks, Case.
Tim: I just want to say before we start that I didn’t get to make my Jets prediction last week, so I’m going to go back and say that the Jets beat the Pittsburgh Steelers. And then this week coming up, they’re going to lose to the Miami Dolphins.
Casey Mullooly: Dolphins are hot.
Tim: They are. The first time the Jets won I was on the podcast, and we talked about the Jets. So, just wanting to get some good juju going here for the Jets.
Casey Mullooly: It’s more of the fact that you’re here doing it, and I think that that’s what’`s really important. It’s also interesting, because they’re playing Pittsburgh Steelers, and episode 412.
Tim: That is pretty coincidental.
Casey Mullooly: Yeah.
Tim: So, that is the area code.
Casey Mullooly: So this week, we’re going to talk about all things bond-related. Bonds have been making headlines, as well as stocks have been this year. It’s kind of been an outlier year, like we’ve talked about in the past, for bonds, with rates going up as much as they have. The bond math is kind of tricky, but just the simple headline explanation is, if bond price or if yields are going up, like they have this year, bond prices go down. So, you kind of have to factor that in when you’re doing all of your bond math.
But I think we wanted to start out talking about a more basic bond idea here, and that’s the fact that there are short-term bonds, intermediate-term bonds, and long-term bonds. So guys, what are the differences, and how should those different types of bonds be utilized when building a portfolio?
Tim: Well, I mean, like you said, all bonds are not created equal. So short-term bonds have shorter maturities, and they’re typically less volatile than intermediate-term bonds, which are less volatile than longer-term bonds. So if you’re using bonds in your portfolio as your fixed income, safer investments to pull money from if you’re taking distributions, the decision between short-term bonds or long-term bonds is pretty important. Because longer-term bonds can fluctuate, almost in a stock-like manner, whereas you’re less likely to see that from the shorter-term bonds.
Tom: The analogy that I learned when I was a baby stock broker was, trying to explain this to clients was, imagine you’re going to the top of the Empire State Building on a windy day. So when you’re in the lobby, like a short-term investment, you don’t feel that wind knocking you around. But go up to the top, to the observation deck on the Empire State Building on a windy day, you’re going to get knocked around. That’s what happens with longer-term maturities. These things move around like stocks, but in most instances you get a higher yield for taking that much risk.
Casey Mullooly: Right. So the idea is that … Go ahead.
Brendan: Not to get too philosophical, but you could think of stocks as super-duper long-duration bonds too. Because basically all you’re doing, if you’re running a discounted cashflow model … Not that most folks are out there doing that sort of stuff. We had to do it for-
Tom: But we are.
Brendan: … CFP courses and things like that. But basically you’re trying to calculate the value of future cashflows from a business. And in a way, they are just really long-term bonds. And the prices, in terms of volatility experience, I guess if there were something above the top of the Empire State Building, that’s where the stocks would hang out.
Casey Mullooly: So the idea is, there’s this word, duration, that’s often used when we talk about bonds. So the idea is that the long-term bonds, their duration is 30 years, and then intermediate-term bonds are more like seven years, and then short term bonds are-
Brendan: Three and less.
Casey Mullooly: Right. One and two.
Brendan: Yeah.
Casey Mullooly: So the further out you go, the longer your duration, the more risk there is. Because that’s when your money will be returned to you, is basically the idea.
Brendan: Or stuff could happen in the interim. Basically, the price is moving around because of what’s going on with interest rates, like you said. So, if you’ve got 30 years-
Casey Mullooly: Anything can happen.
Brendan: 30 years ago, I was two years old. So, a lot’s happened to interest rates since then. So the shorter the period of time is, the less interest rate risk or credit risk you’re bearing as somebody putting money into a bond. Whether it’s to corporation or the government. Yeah.
Casey Mullooly: Right. So I kind of wanted to talk about a thread that I found from Rubin Miller, who’s a CFA on Twitter, and he looked at comparing, “Well, what happens when bond prices go down but yields go up?” It’s been this weird dynamic this year. I know we’ve said it on a couple podcasts, and it’s true that bond yields are more important to returns than the bonds price is. But the bond’s price, it also factors into that equation as well.
Brendan: The price volatility is basically noise, though. If you’re investing in high-quality fixed income, you anticipate you’re going to see the prices move up and down over time. But as you reach the maturity of the bonds, or the duration, the average duration of a portfolio of bonds, like a bond fund, you’re going to get to that point in time and it’s probably going to be about nothing.
And we can say the same about other assets. I think currencies fall into that basket too. We get caught up in terms of, I mean, this year the dollar in terms of its strength versus other currencies. But if you look at a long-term chart of currency prices, it’s a zero-sum game, which is why the degenerates trade things like currencies. Because you can’t buy and hold those assets and succeed. Same thing as commodities, in my opinion. You have to time your entries and exits, because they’re all going to balance out to nothing in the long run. Not to take us on a tangent there, but …
Casey Mullooly: No. It’s helpful context there.
Tom: I think, before we delve in a little further, a question that tends to come up a lot. It came up a lot 25 years ago, and amazingly, I’m being asked this question again in 2022. That a bond, if we hold it to maturity, we’re going to get our money back plus interest. But a bond fund or bond ETF will never actually mature, and that kind of ties in with what Miller was talking about on his thread. That as these bond funds have maturities that come due, that they roll off and money gets reinvested at today’s rate.
So there’s a lot of folks that love looking at, what’s the current yield on a bond fund? Or what has the one, three, and five-year returns been like on bond funds? And they compare them like they would looking at a growth mutual fund or a growth ETF. It’s not the same, because it’s not going to give you an indication of what that bond fund is going to return you in the next 12 months, in the next three years, in the next five years.
Brendan: Yeah. I mean, I think the biggest misconception between the individual bonds versus bond fund thing is that the person who’s saying that they would prefer an individual bond because they eventually get their dollars back is forgetting that they’re going to get their nominal dollars back in the future. Which is not desirable, because the returns that we eat are after fees, after taxes, after inflation.
And that’s what we should care about. I understand the idea of putting in a hundred, collecting some interest, and getting a hundred back is really nice. But the reason, usually, that interest rates go up in the interim and cause losses in bond prices temporarily is because we’re experiencing inflation. That’s usually what pulls interest rates up, which has been the case this year. So if you’re now in an environment where inflation is 7, 8, 9%, I don’t know that the idea of getting your nominal dollars back at maturity is-
Tim Mullooly: You’re getting 92 or $93 back, conceptually.
Brendan: Yeah. It’s not such a great thing, and you bear all the reinvestment risk of taking the proceeds from that bond, and then reinvesting at prevailing interest rates then. When basically, a bond fund is just a larger-scale version of the bond ladder that you’ve agreed to pay some company that provides an ETF or mutual fund to make for you, where you’re reinvesting all along the way. So, it kind of smooths out that reinvestment risk that you bear by trying to pick individual bonds out.
Casey Mullooly: Yeah, and you don’t have to do it yourself. So, less of a headache there.
Brendan: Yep.
Casey Mullooly: So, the study looked at … Or this was a study done by DFA. We’ll link to the chart in the show notes. You should look at the chart, because like they say, a picture paints a thousand words, guys. So, there are two scenarios that DFA compared here. The first scenario is with rates starting and remaining at 1% throughout the entire bond fund’s duration. The second scenario is, interest rates immediately increase to 4%.
So remember, bond yield goes up, the price of the bond goes down. So it immediately increases to 4%, and then it remains at 4% throughout the remainder of the period. We’re starting out with $100,000 here. In scenario one, you have $100,000 to start with. In scenario two, since interest rates jumped up immediately, you’re starting out with just about $86,000.
So, those are the initial losses that you have to deal with.
The chart then shows that the breakeven point in time is year five. In year five, you would have the exact same amount of dollars in both scenarios.
But if we go out to year 20, the scenarios look completely different. In scenario one, the steady 1% throughout the entire 20 years, your $100,000 turned into just over $122,000. But in scenario two, the initial increase in yields, your bond price dropped to 86 at the start, and then you earned 4% throughout that entire time.
Your ending portfolio value would be just over $189,000. So the point being, if your time horizon is greater than the bond’s duration, then yields rising is a good thing. It just might take a year, or two, or three to make your money back. But over the longterm, $122,000 for the 1% bond yield versus $189,000 for the 4% yield. That’s a pretty big difference.
Tom: Yeah, and it’s really uncomfortable taking a big hit. Like you said, your 100,000 turns into 86,000 if you see the yields go from 1% to 4%. That’s what happened this year. So seeing a relatively safe investment down 14%, or in your example, $14,000, people open their statements and they flip out. Because they’re like, “Wait. I thought this was supposed to be safe.” It is safe. So if you need to rip up the script and say, “I need my money back, or I need my money now,” well, now, wait a minute. We’re changing the terms.
Brendan: Well, right.
Tim: So, there was a mismatch.
Brendan: So in this example, you put money into it. Let’s call it an intermediate bond fund. If you had short-term needs in terms of something that was less than the fund’s maturity in this, or duration, is five years. If you had needs for five years and sooner, this is why there are different kinds of bonds, like Tim led off telling us about. Where you can match those to when the money is going to be needed, and not take this ride with money that you’re going to need sooner than five years.
Tim: Right. When we build our ETF bond fund mix for people, we use a type of bucket approach where you have short-term bonds for short-term needs, if you’re pulling money from the account over the next one to two years. And then we have a mix of intermediate and longer-term bonds that can withstand and eventually break even, like Casey was just talking about, over the span of four, five, six years.
However long. And as that short-term bond fund bucket gets emptied, it gets replenished after a few years. So, having sort of a rolling bond ladder of bond ladders. A confusing way to say it, but …
Brendan: If our stocks are in the super-duper long-term bonds, then yeah. It’s just one big conveyor belt feeding off itself-
Tim: Exactly.
Brendan: … the entire time. We’re replenishing buckets as they’re depleted with the slightly-longer-term things. And if we’ve given them the time they need to do what we know they can, then the odds of us having a good outcome are solid as long as we don’t freak out and do anything crazy in the interim.
Tim: Yep.
Casey Mullooly: I’m just going to play devil’s advocate here for a second, because that’s my job as the host.
Tim: Let’s do it.
Casey Mullooly: But I know, Tim, you said that if people need to draw money from their account, we’re usually using up that in the short-term-bond-fund bucket. What happens in a situation where someone would need to draw more money from that bucket than is allocated to it in a year like this?
Tim: Well, I mean, like I was talking about, there would be a mismatch of duration. I think that in that circumstance there’s some sort of mismatch in the overall allocation, or the plan in general, or the cashflow needs, or something went awry. So obviously, you can’t predict the future. So, there could be a year where someone needs to take more than what we have allocated to short-term bond funds. But it shouldn’t happen continuously, because then the communication, there was a breakdown between the advisor and the client somewhere along the way.
Tom: On a related note, and we were talking about this before we turned the mic on, we don’t always have to have 100% of the client’s assets.
Brendan: We shouldn’t.
Tom: Yeah. When we build plans for clients, we tell them, “This amount of money should be stuffed away at the bank.” That’s where it should be, for emergencies.
Brendan: So, we got the bank. And then usually, to some degree, depending on the type of investor, we then beyond that have this short-term-bond bucket that is the immediate liquidity lever, so to speak, from the portfolio itself. And then beyond that, we have the intermediate-term bonds, which is what everyone is bummed out about this year. Us included. The losses in the short term, obviously painful. But these are assets that are in-betweeners, let’s call them, in the portfolio.
We’ve got our really short-term stuff. You’ve got your stuff at the bank. We’ve got out really long-term stuff. The stock market stuff, where we expect volatility to occur, and we have this in-between bucket. And it stinks that aggregate bond index funds are down between 10, 15% this year.
But they’re almost yielding 5% now, like the example that we just used.
So moving forward for people, even if you’re a newly-retired person, let’s say, in their 60s, you’re going to be a holder of bonds for the next 20, 30 years, God willing. So the idea that we have to ride out five years to break even and then earn better returns, that’s all right. I mean, obviously I’d prefer to get the better returns and not endure the losses. But no pain, no gain.
Tom: Really well-said.
Casey Mullooly: Took my breath away.
Tom: Yeah.
Casey Mullooly: So, we just kind of wanted to walk through and talk about what’s been going on. I know we’ve talked about it a couple times now, but talk about it again because it is a big headline-making thing, with rates going up and bond prices doing what they’re doing. So that is going to do it for episode 412 of the Mullooly Asset Podcast. Thank you, as always, for listening. We’ll be back with you next week.
Speaker 5: Tom Mullooly is an investment advisor representative with Mullooly Asset Management. All opinions expressed by Tom and his podcast guests are solely their own opinions and do not necessarily reflect the opinions of Mullooly Asset Management. This podcast is for informational purposes only, and should not be relied upon as a basis for investment decisions. Clients of Mullooly Asset Management may maintain positions and securities discussed in this podcast.