We hope you are doing well. Here is a recap of market performance for the month of February and year-to-date:
Stocks increased during the month of February. US small stocks performed best, followed by US large cap and international stocks. Bonds, however, have lost money both for the month and the year, as interest rates continued to rise.
Why Do Interest Rates Matter?
Interest rates reflect the price of money. Because the price of money has a big impact on economic growth and the financial markets, we watch changes in interest rates closely for the following reasons:
- Essentially, interest rates reflect the health of the financial system. When interest rates are increasing, it can reflect higher inflation, higher economic growth, or both. The opposite is also true – lower interest rates reflect lower inflation, lower growth, or both.
- Interest rates are the main deciding factor for expected returns on a bond investment. If you buy a bond, what you receive when the bond matures is your original investment, plus all the interest payments. So generally, the majority of the return is attributable to interest.
- In the market, the price of bonds change based on changes in interest rates. When interest rates increase, bond prices go down, causing a negative return.
Factors 2 and 3 have a big influence on our decision making with regard to bond investments. If interest rates are high and decreasing, bonds are attractive. If rates are low and increasing, bonds become less attractive.
The following chart shows the interest rate associated with a ten year US government bond:
From 2012 – 2020, the yield on this bond never declined below 1.4% until the recent pandemic began. On March 9th, 2020, the ten-year rate bottomed at 0.4%, but has been recovering since. Over the past 6 months, this recovery has accelerated, increasing from 0.5% on August 6th, 2020 to its current level around 1.45%.
So, what does this mean?
- In general, this rise in interest rates is good. It reflects increased confidence in the economic recovery as the pandemic recedes. When bond yields crashed last March, it indicated an environment of extreme panic and fear. Zero interest rates are not healthy for the economy or markets.
- The current environment has been difficult for bonds. Low and increasing rates make it very hard for bondholders to make money. However, future rates of return increase with higher rates, so in the longer term, this should benefit bondholders. In the meantime, we have invested in shorter-term bonds which mature sooner and have less price sensitivity in the current backdrop.
- Bonds still serve as a safe asset that helps diversify your portfolio. When bonds do poorly, they may decline by a couple of percent. (When stocks do poorly, they decline by much greater amounts.)
- We are approaching a significant inflection point. While we aren’t sure exactly what the future holds, the 1.4% level has been important in the past. In 2012, 2016, and 2019, rates started to go higher at this point. When rates went lower in 2020, they crashed quickly. Ideally, the ten-year rate will continue to go higher over the coming months and years, which would indicate a healing and healthy economy.
We will continue to pay close attention to interest rates. If you would like to discuss this further, please let us know