As a follow-up to my commentary last month, volatility in the bond market has accelerated further as inflation continues to rise. While most bonds are experiencing their worst start to a year since 1980, all is not lost.

As a reminder, interest rates and bonds have an inverse relationship—that is, when interest rates increase, bond prices fall, and when interest rates decrease, bond prices rise. Is this always the case? No, but generally speaking, this premise holds true.

We are likely facing an extended period of higher interest rates, which means more volatility lies ahead. Still, rising interest rates should be viewed as a positive for bonds over the long term.

Rising Rates

First, let’s acknowledge how incredibly well bonds have performed over the past decade. Rock-bottom interest rates and the Federal Reserve’s seemingly unlimited quantitative easing helped spark one of the best return periods for bonds.

For much of the past decade, yields have been suppressed, making it difficult to earn a respectable yield from any lower-risk investments (i.e., money market, CD, U.S. Treasuries). Many bonds increased in principal since cash sitting on the sidelines eventually found its way into various bond asset classes, pushing values higher.

Fast-forward to today and stubbornly high inflation has changed the Federal Reserve’s tune. Last month, the Fed raised interest rates for the first time in over three years, and it plans on six additional increases this year! This is a major shift from November 2021, when the Fed was signaling patience and appeared in no rush to raise rates.

With inflation raging higher, investors need to be aware that bonds will likely earn a negative inflation-adjusted return this year. The same could apply to equity markets. As “scary” as this may sound, bondholders should embrace higher rates as they’re just what the doctor ordered. Think of them as short-term pain for long-term gain. While higher rates will likely cause bond values to dip more in the short term, the trend should be beneficial in the long term.

To put things in perspective, the U.S. 10 Year Treasury, which is considered the safest, deepest, and most liquid market in the world, was yielding ~1.34% in December. Today, it’s nearly 2.5%! The yield nearly doubled in a matter of four months!

Moves of this magnitude in the treasury market are uncommon, and anyone who purchased a 10-Year Treasury a mere four months ago is earning much less than if purchased today.

Now, the bright side is that as bonds mature, the proceeds are reinvested into newly issued bonds that pay higher interest. The bonds that mature in 2023 will purchase newly issued bonds at even higher rates. The key here is managing your duration to minimize the volatility along the way.

With corporate default rates at historic lows, an orderly rise in interest rates alone will not derail the U.S. economy, which means they should be welcomed. The wild card, of course, is whether inflation remains elevated for longer than expected. This would force the Fed to raise rates more aggressively, which could drastically slow economic growth and push us into a recession.

With higher rates come higher yields—eventually.

Discuss your situation with a fee-only financial advisor.

The commentary on this website reflects the personal opinions, viewpoints and analyses of the Divergent Planning, LLC employees providing such comments, and should not be regarded as a description of advisory services provided by Divergent Planning, LLC or performance returns of any Divergent Planning, LLC Investments client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Divergent Planning, LLC manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.

Divergent Planning, LLC provides links for your convenience to websites produced by other providers or industry related material. Accessing websites through links directs you away from our website. Divergent Planning, LLC is not responsible for errors or omissions in the material on third party websites, and does not necessarily approve of or endorse the information provided. Users who gain access to third party websites may be subject to the copyright and other restrictions on use imposed by those providers and assume responsibility and risk from use of those websites.

Divergent Planning, LLC is a Registered Investment Adviser. Advisory services are only offered to clients or prospective clients where Divergent Planning, LLC and its representatives are properly licensed or exempt from licensure. This website is solely for informational purposes. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Divergent Planning, LLC unless a client service agreement is in place.

General Notice to Users: While we appreciate your comments and feedback, please be aware that any form of testimony from current or past clients about their experience with our firm on our website or social media platforms is strictly forbidden under current securities laws.