An Explainer: Just What is Happening with Bond Prices?

For those of you who are continuing to look at your statements, despite our advice to the contrary, you have undoubtedly noticed that your bond and bond fund prices are falling.  We all know that bond prices fall as interest rates go up but what does that really mean and what should we, as investors, do about it?

First of all, experts have expected interest rates to increase for 15 years, so the fact that that is now happening is not a surprise. What is a surprise is the speed with which it has happened.  But of course, we are also now experiencing unprecedented inflation.  Bonds are still a critical part of our portfolios to provide generally “non-correlating” performance with equities and to provide income and lower volatility – usually.  But bonds are not a great inflation hedge – which is why we usually recommend TIP’s which have lower coupons but better overall yield when inflation is increasing. 

• If you own single bonds, remember that the day-to-day fluctuations of bond prices (as ugly as they can be) do not impact the face value redemption price at maturity. And interest continues to be paid until the day the bond is sold or matures. If you own Treasury Bonds (including TIPs of course) the default risk is really non-existent.

• If you own shares of a bond fund, your share price has been declining, rapidly. But the monthly interest payments are still intact, and as bonds mature in the fund, they will be redeemed at face value and replaced with higher-paying (or higher-yielding) bonds. That eventually helps the overall investment to recover. The replacement of the existing bonds in the fund obviously happens more quickly if the fund owns shorter duration (time to maturity) bonds. Think Vanguard Short Term Bond Fund. Over time, the re-invested dividends will compensate for the decline in price, but this does not happen immediately.

In this period of bond price volatility, one strategy we are starting to selectively pursue is using a TIP fund instead of single TIPs.  The fund manager of the TIP fund buys multiple duration TIPs within the fund to better manage the interest rate risk.  This is a discussion topic with many of you as we talk over the next quarter.