Positive Side Of Falling Bond Prices

If bond prices move inversely with yields, how can there be any good news in the past few months’ sharp rise in Treasury rates?

Andrew W. Lo and Stephen R. Foerster’s recently published book, In Pursuit of the Perfect Portfolio by (Princeton University Press), is both immensely informative and highly readable. It consists mainly of profiles of, and interviews with, the major architects of present-day investment theory and practice. They include such luminaries as John Bogle, Jeremy Siegel and Robert Shiller. Lo and Foerster’s chapter on Martin Leibowitz, the Fixed Income Analysts Society Hall of Fame’s very first inductee, is especially pertinent to income investors in light of recent fixed income developments.

Between August 2, 2021 and the recent peak on January 18, 2022, the ten-year Treasury bond yield soared from 1.17% to 1.86%. As the financial press incessantly reminds us, bond prices go down when yields go up, so it is hardly surprising that the investment grade ICE BofA U.S. Corporate Index lost substantial value over that interval. That index’s -5.63% price return for five-and-a-half months far exceeded a full year’s income.

Some of Martin Leibowitz’s earliest and most important work at Salomon Brothers, in conjunction with bond research pioneer Sidney Homer, involved the critical importance of reinvestment income to bond returns. In brief, a bond’s rate of return over its life will equal its promised yield-to-maturity only in the special (and improbable) case that all its coupons are reinvested at the same, initial rate.  If you buy a long-term bond with a 3% yield and yields then decline, you will get the short-term gratification of a price gain. Less happily, you will reinvest your coupon income at a rate lower than 3%, with the result that your return through maturity will be less than the 3% you expected.  

At present, the flip side of the story is most pertinent. Yes, the value of your bonds has fallen as yields have risen over the last several months. If long-term rates remain elevated, however, your return through those bonds’ maturities will be higher than you bargained for, thanks to increased reinvestment rates.  This is the essential part of the story that the financial media’s day-to-day reporting on the debt market misses.

Ah, but what if you are past the wealth accumulation stage and are no longer reinvesting the income from your portfolio but instead withdrawing it to cover living expense? The good news is that the hit to bond prices has not reduced your income, provided you do not own any very-low-quality issues that went into default. Note, however, that “income” in this case means nominal income, rather than real, i.e., inflation-adjusted income. The recent escalation in bond yields reflects a rise in the expected inflation rate, so you need to be concerned about the reduced amount of goods and services that a static number of dollars of income can purchase.

To address that concern, you must think about income investing in broader terms than fixed-rate bonds alone. A portion of your income portfolio should be in assets that have the potential to increase their payouts over time. Carefully selected dividend growth stocks and closed-end funds can play a useful role in this strategy. Leveraged loan funds and variable rate preferreds also fit; their payouts increase as interest rates rise. In addition, the interest payments on Treasury Inflation Protected Securities (TIPS) are calculated on principal amounts that rise along with the Consumer Price Index.

Homer and Leibowitz made their discoveries about the vast impact of interest-on-interest a long time ago. This year marks the fiftieth anniversary of the publication of their classic, Inside the Yield Book, the bible for many a bond sales-and-trading trainee over the decades. As an even earlier duo [1] wrote, though, “it still is news.” The daily papers are currently informing investors about price deterioration on the fixed income investments they counted on as ballast in portfolios designed for long-run appreciation, yet the critically important impact of higher reinvestment rates goes unreported.

For more from Martin Fridson, get Forbes/Fridson Income Securities Investor.