The Federal Reserve (the Fed) on Wednesday cut its target interest rate by 0.5 percentage points, the first cut in over four years and an aggressive move to change the interest rate environment in the U.S.
Rate cuts from the Fed have the effect of repricing the entire bond market. Therefore, it is worth reflecting on a few basic facts of how interest rates impact bonds. Fixed income is an important part of a diversified portfolio, and so this is likely to be at the front of many people’s minds right now.
The Fed controls the federal funds rate, which is the interest rate at which banks lend to each other overnight. This rate serves as a benchmark for short-term borrowing rates. Although the Fed only has control over short-term rates, when short-term rates are lower, it conveys an expectation of lower inflation in the future, which reduces the yield investors demand for long-term bonds as well. These expectations are one of the key ways that Fed actions influence the entire yield curve.
Before diving into a refresher on bond math, it’s worth highlighting that despite the Fed making its first cut a large one, we still don’t know exactly how far or how fast they are going to cut rates during this cycle. It doesn’t necessarily mean that we’ll be quickly headed back to the ultra-low interest rate environment of 2021. We don’t know exactly how long the Fed’s rate cutting cycle will last, or how much it will impact the entire universe of rates.
With that said, the key bond terminology to remember (and how it is affected by an interest rate cut) follows:
Bond Yields and Prices: Though familiar to many investors, it’s important to remember that bond prices and interest rates move in opposite directions. When interest rates on bonds are falling, like we expect, it means the price of those bonds will be rising.
Bond Coupons: The coupon payment is the fixed dollar amount that a bond pays. For most bonds, this rate is fixed when you buy the bond. For example, if you buy a $1,000 bond at a 5% interest rate, then this bond has a coupon of $50 per year. The coupon on bonds you already own won’t change until your bond matures.
Yield to maturity: The yield-to-maturity is a measurement of how much an investor will earn if they buy a new bond and hold it until maturity. When interest rates fall, the yield to maturity also falls.
These basic points help us keep straight what’s happening in bond portfolios right now, and here’s our key takeaways:
We own bonds for income, and that hasn’t changed. Even when rates and prices change in the market, the coupon on bonds you already own doesn’t change. For bond investors who have invested for income, their current bonds will continue to generate the income they’ve received previously. For the investor who bought a $1,000 bond with a $50 coupon, that $50 will keep coming until the bond has matured.
Bonds remain a diversifier. One of the key reasons that bonds are such a useful diversifier to a portfolio is that when rates go down, the price of bonds goes up. That’s a ballast for your portfolio. When interest rates are higher, as they have been over the past year, the diversifying power of bonds relative to stocks is greater than when interest rates are lower. The logic here is simple. Bond yields and prices move in the opposite direction. The more that the yields on bonds fall, the more the price of those bonds is able to rise.
What will change is the impact of reinvestment. When bonds mature, if one wishes to reinvest the proceeds, they must do so at the new prevailing interest rates. For now, if interest rates are lower, reinvesting in bonds will lead to reduced income.
With shorter duration, comes more reinvestment risk. There is a tradeoff with bonds that have a short duration to maturity. On the one hand, they are less susceptible to changes in interest rates. A one percentage point decline in interest rates would lead to a 5.5% increase in price for a two-year bond. It would lead to a 21.2% increase in price for a 30-year bond. (This effect works in both directions – if interest rates unexpectedly rose, the 30-year bond suffers.)
Short-duration debt is less volatile than long-duration debt as interest rates rise and fall. But because short-duration debt will reach maturity sooner, it must be reinvested sooner – therefore, its reinvestment risk is greater. Money market mutual funds with a duration of 30-40 days possess the greatest reinvestment risk. With the recent decrease in the fed funds rate it appears money market funds will provide less income going forward. Longer duration bonds, by contrast, might be less affected by the recent rate cuts.
For many investors, bonds are confusing, especially in a moment like now when the interest rate environment is in flux. When rates change, it’s a good time to speak to your advisors if you have one.
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