Bonds are loans to corporations, governments, and municipalities. When you invest in a bond, you lend your money so they can operate their organizations. Bonds usually have a stated interest rate, and a maturity date when you get your money back. Bonds trade in the open market and are worth more or less than their face value, depending on prevailing interest rates. Interest rates affect housing prices, and everything else that consumers, businesses, and governments do. For this article, all you need to know is that when interest rates go up, bond prices go down.
In sharp contrast to a bond, is a bond fund. A bond fund is a corporation with shares that go up and down based on the value of the bonds that it holds. It has no interest rate, no maturity date, and can often use your money to lever your investment. When rates go down, as has been the case the since 1981, the value of bond funds go up. But with interest rates now on the rise, values are falling. Inside every bond fund is a person called the fund manager who selects the bonds to buy when investors are adding money to the bond fund, and which to sell when investors are redeeming their shares. As rates go up, bond funds fall, and more and more investors are inclined to redeem their shares. The manager is then forced to sell more bonds. If these redemptions cause an oversupply, prices must fall to entice buyers. That’s bad. Remember 2009?
At the onset of the Pandemic, the Federal Reserve (the Fed) set interest rates very low to help businesses through the economic difficulties of closing, partial re-openings, Delta, Omicron… That is, until now. The Fed has recently stated that they expect to raise interest rates three—even four or more times in the current year 2022. That has sent interest rates higher, and bond funds lower. Adding fuel to the fire is a new process called Tapering. The US Treasury began buying bonds to keep the bond market highly liquid at the beginning of the Pandemic. That’s good because during the Great Recession, the Treasury provided too little “Quantitative Easing” support, sending the world into sharp economic decline. Remember companies like General Motors and Merrill Lynch going bankrupt? Much of that suffering could have been avoided with ample liquidity.
But now with inflation running at 7%, the Fed is faced with two evils: inflation and a delicate economy. It has chosen inflation as the greater evil, so they are raising interest rates to slow the economy. This slower economy in turn lowers demand for goods and services, and that eventually lowers inflation. It’s a long term, painful process that can take years. Remember Jimmy Carter, stagflation, and Paul Volker? We now have Trade Wars with China, a Treasury full of bonds, and supply-chain/inflationary pressure that was “transitory” just 30 days ago.
Back to Tapering. While the Fed is raising rates, the U.S Treasury, who has been buying $100s of billions worth of bonds every week since the Pandemic started, is Tapering (slowing) their purchases, causing yet more supply in the bond market, and driving prices even lower. The Treasury has also stated their intention to sell the bonds they bought back out into the open market. How much are they selling? The answer is $9 trillion. That is $9,000 billion. A number so big that you can safely say that there will be an oversupply of bonds for a very, very long time.
Interest rates are rising, bond supply is increasing, bond prices and the funds that invest in them are falling.
Conclusions
Individual bonds of high quality and short duration are an appropriate investment vehicle to preserve principal, earn interest, provide diversification to equities, real estate, etc. Bond funds in a rising interest rate environment do not provide such protections and should be reviewed for quality and duration.