In the 19th century, German novelist and playwright Gustav Freytag established a framework for storytelling known as Freytag’s Pyramid that has become the centerpiece for how authors often craft their plays, books, and movies. Freytag’s Pyramid has not only served many writers well in their efforts to tell stories but can also aptly apply to telling the story of the bond market. There are five stages to Freytag’s Pyramid: Exposition, Rising Action, Climax, Falling Action, and Resolution. Using these five stages to put our thoughts on the bond market into context, we hope to deepen your understanding and comfort in our firm’s strategy for bonds.
Exposition: The Current State of the Bond Market
In recent weeks, the current yield, or annual return, on a 10-year US Treasury Bond has returned above 4%. Over the past six months, we have seen the 10-year yield fluctuate to briefly touch a high of 5% in October to a low of 3.78% in December. This is historic volatility for the bond market, which is often regarded as “sleepy” compared to the swings in the stock market. Savvy investors have been watching these movements closely, as the 10-year Treasury yield can provide insights into the broader bond market and serve as a barometer for investor’s confidence in the economy.
Before 2022, we had not seen 10-year yields as high as 4% since 2007. Interest rates were forced down to historic lows in the wake of the financial crisis, and strategists have been speculating when interest rates might break out from this low range ever since. For the first time in 15 years, we are officially experiencing a more “normal” level of interest rates, and our team is embracing these appealing investment prospects. We view the current level of rates as a “window of opportunity” to strategically add individual bonds and lock in higher yields in your portfolio for years to come.
Rising Action: Inflation and Federal Reserve Policy
The beginning of our inflation story starts with a virus and subsequent pandemic. While staying home and social distancing protected our health, it caused widespread economic woes, and many people lost their jobs. In the face of an uncertain, downward spiral, the Federal Reserve lowered rates to a near-zero level, and the government injected capital into the economy by issuing stimulus checks. These actions helped the economy rebound dramatically and protected many Americans, but the successful economic re-opening and tremendous subsequent growth started to become “too good to be true.” The expansion was surely welcomed, but inflation lurked in the shadows. As the economy grew at above-average levels, the prices of many essentials in our lives did as well. Given that few things are as detrimental to the economy as hyperinflation, the Federal Reserve had yet another issue on its hands.
To bring the inflation rate down from hyperdrive and return to a healthy 2%, the Federal Reserve increased interest rates 11 times over the past two years. Increasing interest rates acts as a brake pedal on the economy – slowing financing operations, increasing costs of debt, and weakening consumer spending. The Fed’s path forward hinges on its ability to gauge how much longer it needs to keep its foot on the brakes.
Climax: Return of the Bonds
While 2022 was a difficult bear market for stock investors, the silver lining was the bond market. Rising interest rates created true value and attractive forward returns in the bond market. We seized this opportunity and purchased individual bonds that will allow us to benefit from today’s high rates for years to come by “locking in” positions poised to pay 4-5%. Not only do these low-risk positions significantly contribute to your portfolio’s bottom line, but they should also provide you with additional peace of mind that your portfolio is structured to achieve your long-term financial planning objectives. While bonds have always been an important part of portfolio composition, it’s been a very long time since they’ve done so much “heavy lifting” in terms of return.
Given where we are in the interest rate cycle, we have allocated a portion of your holdings in bonds with longer maturities – or redemption dates – that are further in the future. This is beneficial for two main reasons. First, given the inverse relationship between bond prices and interest rates, these bonds will see price appreciation when the Federal Reserve begins to cut rates. Secondly, bond coupon payments always provide portfolios with positive cash flow. This means that if we do find ourselves in a volatile environment, they help serve as a buffer and provide a reliable income stream.
Falling Action: Beware of Reinvestment Risk and Lower Rates
At recent meetings, the Federal Reserve members have articulated they are no longer focused on raising rates but perhaps cutting rates in the future. The speed and timing of these cuts are highly debated. However, all members indicated they expect rates to be lower in 2024, 2025, and 2026. Understanding this near-term trend facing the bond market, we believe there is a high level of reinvestment risk for investors who do not have longer-dated bonds in their portfolio.
Reinvestment risk is the chance that an investor will have to reinvest funds from a maturing fixed-income investment at a rate lower than its current rate. Short-term bonds and CDs have a very high level of reinvestment risk in today’s environment. We believe that holdings maturing in the next 1-2 years are subject to greater reinvestment risk because we agree with the Fed’s projection of interest rates (and, therefore, yields) dropping during this time frame. If you hold or are considering purchasing short-term CDs or bonds, we would enjoy discussing your situation and options in further detail.
To defend against reinvestment risk, we create laddered portfolios of staggered maturity dates with intermediate and long-term holdings. This helps mitigate risk because the portfolio will have bonds maturing at different points of the interest rate cycle rather than all the same time. We also believe it’s important to actively manage bond portfolios. For example, since rates have likely peaked and declines are on the horizon, we have been adding intermediate and long holdings and trimming down our short holdings. Again, we think longer term rates at current levels are very attractive and will provide value for years to come.
Resolution: Hand Crafted Bond Portfolios
We take great pride in our ability to select individual bonds for you and ensure that each client has a portfolio of bonds suited to meet market conditions. Our bond traders have been hard at work taking advantage of investments that have quickly become the cornerstone of portfolios and critical pieces of financial planning success. We are wary of bond funds as it is difficult to monitor underlying creditworthiness, maturities, and portfolio management. While stocks may receive more media and attention, our firm understands the importance of bonds in securing a strong financial future and a steady stream of income.
We hope you find this fixed-income update helpful and please do not hesitate to contact us if you have any questions.
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Your Main Street Research Team