BONDS ARE BACK - Why Duration Matters, Especially Now

Be ready for some numbers – but give this article a shot, it’s going to clarify what may be a big opportunity over the next year or two.

EXECUTIVE SUMMARY: Inflation and the economy have cooled, and interest rates are likely coming down over the next few months. Duration is a measurement of how much bond prices will increase if interest rates come down. Moving a portfolio from low duration investment (money markets, short term bonds) to higher duration investments (mid to long term bonds) can have a substantial impact on your portfolio.

First, it’s important to note that buying a bond and holding it to maturity will give you a predictable return calculated as a “yield to maturity”. However, bonds can be bought and sold prior to maturity for a gain or loss. Between the time a bond is issued and when it matures its price moves in the opposite direction to interest rates. When interest rates go up, bond prices go down. Similarly, when interest rates go down, bond prices go up.

2022 was a prime example of this. The Federal Reserve raised interest rates to combat inflation. As a result, the broader bond market fell over 13%.

It’s widely expected, and in fact the Federal Reserve has projected, that interest rates will come down over the next few months. Inflation numbers have come in and it appears that both inflation, and the economy, are cooling rapidly. In response, the Fed plans to begin cutting rates over the next few months.

What does a rate cut mean to your portfolio?  As interest rates come down, the price of bonds goes up. We could see double digit returns in the bond market over the next year or two.

In fact, the longer the term of the bond, the more it reacts to interest rates. Imagine owning a 2-year bond, paying a 5% interest rate. If the 2-year bonds fall to 3%, your 5% bond will be more valuable since you can only buy 3% bonds in the open market. But, since it matures in only 2 years, its extra value is limited since you only get 2 years of extra high interest.

Now, take that same scenario, but apply it to a 30-year bond. A 5%, 30-year bond would equate to 30 extra years of high interest! In that scenario, your 30-year bond will be worth significantly more.

The price movement in response to interest rate moves is measurable and is tracked by a metric called DURATION. Duration measures how far the price of a bond may move if interest rates move 1%. For example, a duration of 6 means that bonds prices will go up 6% if interest rates go down 1%. If interest rates go up 1%, the price of the bond will fall by 6%.

Short-term bonds, like the bonds in a money market, have low durations, meaning they only move slightly when interest rates change. Conversely, long-term bonds have high durations – their value can swing wildly when interest rates adjust.

Take a look at the long-term treasury bond index. From its peak in 2020 to its bottom in 2023, the index lost over 50% as interest rates went up. Those same bonds, however, could move in the opposite direction if interest rates fall.

It’s worth noting that there is no “universal” interest rate number. Interest rates are measured across a spectrum of maturities by the yield curve.  It’s possible that short-term rates will go down while long term rates will go up. Or for the 10-year bond to see rates come down significantly, while the 30-year bonds see rates come down only slightly. It’s difficult to predict which segments of the market will see the largest interest rate moves, therefore diversity remains important.

Diversifying a bond portfolio, however, means not just looking at different issuers, but more importantly, different maturities. Doing so will allow you to capture the move in interest rates regardless of which part of the yield curve it comes from.

Aggressive investors have typically avoided bonds in favor of equities. We’d argue that bond investments, over the short-term, may see equity like returns if rates come down significantly. Get ready for the headlines: “Bonds are Back”.

Disclosure: The information given herein is taken from sources that IFP Advisors, LLC, dba Independent Financial Partners (IFP), IFP Securities LLC, dba Independent Financial Partners (IFP), and its advisors believe to be reliable, but it is not guaranteed by us as to accuracy or completeness. Securities offered through IFP Securities, LLC, dba Independent Financial Partners (IFP), member FINRA/SIPC. Investment advice offered through IFP Advisors, LLC, dba Independent Financial Partners (IFP), a Registered Investment Advisor. IFP and Pointer Financial Group are not affiliated.