What Rising Interest Rates Mean For Your Retirement Portfolio
Image Credit: Charles Scwhab
It has been a long time in the making, but bonds are finally back in style for investors.
If there is one silver lining to owning bonds in 2023, it’s that the bond market is set to provide investors with attractive yields at lower risk than we’ve seen for several years.
And for those in or nearing retirement, this could mean a big boost to your retirement income.
Specifically, the optimism surrounding bonds this year can be attributed to three key factors:
Starting yields are the highest they have been in years due to the recent rise in interest rates.
Inflation is slowly and stubbornly beginning to fall.
The Federal Reserve is getting closer to the end of rising interest rates, a policy known as Quantitative Tightening.
In this blog post, we will explore the factors that have led to the current situation, explain the relationship between interest rates and bond prices, and discuss what all of this means for bond investors in 2023 and the years ahead.
First, how did we get here?
To understand where we’re at today, we first have to go back to the Great Financial Crisis of 2008-2009 and take a look at interest rates following the crisis.
Do you remember what happened?
Interest rates were slashed to near-zero to stimulate the economy, resulting in low bond returns for over a decade.
Just as interest rates were beginning to rise, COVID happened and rates were again dropped to historically low levels.
In 2022, the bond market went through a huge resetting of interest rates, as rates were raised seven times, ending at 4.50%.
The Relationship between
Interest Rates and Bond Prices
Interest rates and bond prices have an opposite relationship.
When interest rates go up, the prices of existing bonds go down.
This happens because as new bonds with higher interest rates enter the market, they become more appealing and make older bonds less attractive.
2022 proved to be an incredibly challenging year for bonds, thanks to the seven interest rate hikes that took place.
Consequently, the bond market endured one of its most devastating years on record, with the US Aggregate Bond Index plummeting by over 13%.
Image Credit: Fidelity
2023: The Year the Tides Began to Turn
After a decade-long period of minimal yields in the bond market, combined with last year’s brutal -13% return, bond yields have started the year at their highest level in years.
This provided much-needed relief and offered investors attractive yields with lower risk than we’ve seen in years.
Image Credit: Business Insider
Taking a look at the chart below, you can see the staggering difference in bond yields from 2021 and 2022.
This means that an investor no longer has to take on an excessive amount of risk to achieve a healthy return.
Instead, a portfolio consisting of high-quality bonds, such as US Treasuries or Investment Grade Corporates, now offers a 4% - 5% return with minimal risk.
Furthermore, as the Federal Reserve continues to raise interest rates, the impact of bond prices declining, like we experienced in 2022, is less significant because of the higher coupon rates (or payments).
Interest Rates & the Federal Reserve:
What happens next?
One of the main factors that drive bond yields is the Federal Reserve and its actions regarding interest rates.
Many experts believe that we are nearing the peak of interest rate hikes and will soon start to see rate cuts.
However, the timing of these rate cuts is uncertain and remains one of the most contested topics.
Much of the timing of these potential rate cuts hinges largely on inflation and the monthly data.
The Federal Reserve today (as of June) finds itself in a "wait-and-see" holding pattern as it continues to fight inflation.
It is likely that the Fed will not start cutting rates until inflation begins to trend further downward, closer to the 2% target.
As shown in the chart below, inflation is moving in the right direction, albeit very slowly, but it still has a long way to go as it has been hovering around 4.5% for several months.
What does all of this mean for me
as a Bond investor in 2023?
Let’s begin by discussing some bond basics before we move on to how this will impact your portfolio.
BONDS 101: Inverse relationships
Remember what was said earlier about the relationship between bond prices and interest rates.
They move in opposite directions.
As interest rates go down, the price of your bond increases.
This allows you to sell your bond for a higher price because other investors are willing to pay more for a bond with a higher interest payment.
And depending on the types and length of maturity of the bonds you own, falling interest rates can be a good thing for your portfolio as these bonds would increase in value.
Image Credit: Fidelity
It is also another reason why diversification, even among bonds, is so powerful.
A second factor to keep in mind when it comes to bonds is yield and its relationship to bond prices.
Much like interest rates, yield moves in the opposite direction of bond prices.
So, in an environment like we find ourselves in today, with interest rates anticipated to be soon declining, this would increase the price of bonds.
As it relates to yield, as bond prices rise, bond yields decline.
Image Credit: Fidelity
This means new investors are faced with a decision:
Either they’ll have to settle for the lower interest rates on new bonds being issued on the marketplace or pay extra for the older bonds with a higher interest rate.
If someone buys an older bond with a higher interest rate, they will still receive the higher coupon rates. However, they will have overpaid for the bond, when compared to it's orignal price, resulting in a lower yield.
What Does This Mean for Your Portfolio?
First and foremost, diversification remains more important than ever and the bond market is ripe with opportunity to build out a solid portfolio that can provide investors with income and price appreciation unlike we've seen in years.
Short-term bonds are paying in the neighborhood of 4% to 5% and as temping as it may be to put all of your eggs in this basket and lock in rates, we have to also remember that yield is only one piece of the equation.
Tying too much of your money up in the short-term space could open you up to reinvestment risk—the risk that they will have to reinvest maturing securities when yields are lower
Think of diversification as a BOTH AND situation.
With interest rates anticipated to fall at some point in the future, this opens the door for longer-maturing bonds and price appreciation in your retirement portfolio.
Again, BOTH AND.
Image Credit: Charles Schwab
Managing Director of Fixed Income at Charles Schwab, Kathy Jones, had this to say about bonds of varying maturities and their impact:
Image Source: Charles Schwab
According to UBS, “With the peak Fed Funds forthcoming and a potential recession looming, we believe it’s time for investors to prepare for a transition into longer duration…the opportunity over the intermediate term appears very attractive.”
Duration is a fancy way of referring to bond maturity and how long it takes for an investor to recoup their money.
A longer duration means a longer time period, while a shorter duration refers to bonds that mature sooner.
💡IT'S IMPORTANT TO KNOW..
Regardless of what happens in the next few months or even years, entering into a higher interest rate environment now offers more opportunities for investors and their portfolios.
When considering adding bonds to your portfolio, it’s important to remember the impact of diversification between various maturity dates (short term vs. long term), as well as the quality and rating of the bonds you select, is critical.
Working with an experienced financial advisor is crucial now more than ever to ensure you have the right mix that is appropriate for your retirement needs.
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