Last month we began the discussion on how a change in interest rates will affect your bond investments. The most important takeaway from this was to recognize why interest rates are changing. In the previous article, we discussed the return of different types of bonds in 2020 and early 2021 as we went through the fear and recovery phases of the Covid-19 pandemic. (Click here to read this article.)
The next most common reason interest rates may change materially is inflation, which is essentially consumers and businesses paying higher prices for goods and services. This next point may seem counterintuitive, but when inflation strikes companies often see their revenue increase as a result of higher prices because if they are raising prices, it stands to reason they should see higher revenues. However, one of the most common reasons companies raises prices is due to higher expenses. This is why an inflationary environment can lead to a decline in profitability. This is a key observation because as a bondholder you are not as concerned about profitability, rather solvency or more specifically the ability the company has to pay its bills is what matters. Since these payments are made before any profits can be distributed to shareholders, rising inflation will not necessarily result in a decline in a company’s credit quality or ability to pay its debts. Accordingly, corporate bonds have typically held up better during inflationary periods than U.S. Treasury bonds since they start with higher yields.
Let’s now project into the future a scenario where interest rates rise due to escalating inflation fears. If this occurs the value of both U.S. Treasury and corporate bonds will likely fall in tandem, but the degree of decline will vary. Rising inflationary pressures are most heavily felt by longer duration, lower-yielding, higher-quality bonds like 20 years or longer U.S. Treasuries. Shorter duration bonds within the corporate investment grade or high yield sectors typically see less downside pressure since these bonds mature much sooner. Thus, if you are concerned about inflation, minimizing exposure to long-term U.S. Treasuries in favor of shorter-term corporate bonds is prudent.
The idea that short-term bonds can merely minimize losses in an inflationary environment can sometimes lead investors to decide to shun bonds altogether. We think this is a mistake because it assumes you have the ability to predict changes in inflation, which is just as difficult as timing the stock market. Keep in mind if inflation concerns cause interest rates to rise sharply in a relatively short period of time this would likely be very difficult for our economy to handle. The best example of this is the housing market. As we all know, mortgage rates near all-time lows are creating an insatiable amount of demand by home buyers. Imagine if a year from now mortgage rates were 2% or higher. How devastating would this be to the housing market and what would the ramifications be for the rest of the economy?
Most Americans don’t realize our country has 50% more public and private debt now than we did at the peak of the global financial crisis in 2008.1 Needless to say, we do not have enough money to pay this off and it will have to be refinanced constantly over the decades ahead of us. Should interest costs rise sharply, this additional expense will cause severe strain on public and private spending, undoubtedly weakening the economy as a result. It is extremely unlikely the stock market would emerge unscathed from this type of deleveraging. So, while higher interest rates due to escalating inflation fears would become a headwind for your bond investments, it is unlikely stocks would provide a haven to investors as many may think. With this in mind, maintaining proper diversification amongst all types of stocks and bonds remains the best way to navigate the current investment environment.