Bond prices have been coming down a lot ytd 2022. Does this mean that we are heading towards a bond bull market?
Here are some basics on bond prices -
Bonds usually pay interest semi-annually which can be a good income source for retirees. Investors will typically look for the highest paying interest bonds with the highest credit quality. However, while rates have been at historic lows, investors could not locate bonds paying much interest at all.
For this reason, bond prices with any coupon had been trading above par value (usually $1,000 per bond a.k.a. maturity value) over the last several years. This is called a bond premium, which lowers the total return of the bond, because when the bond matures, you will receive the maturity value rather than what you spent. For example, for each bond purchased at $1,200 you will receive $1,000 at maturity. Before the rate hikes, some bond prices were as high as $1,200-$1,400/bond.
Rising Interest Rates in 2022 -
The recent Fed rate hikes have caused existing bonds to drop in price. Many of these bonds are now trading around $900-$950/bond (discount). Newly issued bonds have had higher coupons/interest rates this year. For example, the two year treasury is yielding around 4.25%.
This could be good news for investors buying bonds today. The bond price discount adds to the total return of the bond as long as the issuer can pay back your principal. However, these bonds may not have the highest annual interest and as more newly issued bonds become available with higher interest, those discount bond prices could continue to drop.
The best news of the recent rate hikes is that it is easier for retirees to purchase higher interest paying investments from any new issue or existing bond. For example, as bond prices drop, their current yields have been rising (annual interest divided by purchase price).
You will be able to find some corporate bonds with total returns of about 5-6%. This is making bond investments look more attractive, but the rates are still not matching current inflation which means your real return is still negative. If the fed can attain their goal of bringing inflation down to 2%, then bonds with a total return of 5-6% could add some real return (3-4%) to your portfolio.
2023 Rate Reductions? -
In addition, the Fed may not lower rates anytime in the near future. In fact, the fed states that it will continue hiking for the foreseeable future which is important to mention because total returns on bonds in a rising interest rate environment are typically not very good, as we see from YTD 2022 price drops.
Those anticipating a shift in fed rate policy, meaning that the Fed begins easing (reducing rates) again anytime soon or later in 2023, may be more bullish on bonds right now because they hope for price appreciation for bonds if rates decrease again later next year.
Easing may not happen as soon as investors hope. The Fed has the ability to maintain rates by taking a 'pause' in rate hikes which could delay any bond price appreciation that would come from shifting Fed policy, which would include rate reductions or treasury bond buying.
Lastly, even if the Fed begins lowering rates next year, they may not lower them by very much. This means that not every bond would appreciate in value as some have higher coupons than others (everything else equal).
Careful when purchasing bonds or creating a bond ladder. There could be some opportunity in fixed income investing but there are signs that bond prices have further to fall. Working with a fiduciary who does not receive bonus incentives or commissions/mark ups will help.
Feel free to reach out for some help with bond investing or a second opinion on your investments because bonds and bond ladders are not for everyone. The recommendations are given while separating the advice cost from the transaction cost. Bulldog Financial Planning can help to see if a bond portfolio is right for you.