A Bonding Experience
by Frederick R. MacLean

“I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a 400 baseball hitter. But now I would like to come back as the bond market. You can  intimidate everybody.”
– James Carville

When it comes to the financial world, the stock market usually gets all the media attention, but from time to time, the bond market – the stock market’s larger, quieter, brooding older brother – steals the spotlight. The above quote from Clinton administration consultant and omnipresent LSU football fan James Carville was made in reference to the “bond vigilantes,” a group of institutional bond investors who were reputed to impose discipline on the global bond markets in the early 1990s.

In 1990, in response to a brief recession, the US government increased government deficit spending and the Federal Reserve reduced interest rates. Loose monetary  conditions eventually stoked fears of inflation, which led professional bond investors to sell en masse as they demanded higher interest rates to compensate for the higher risk of inflation. Eventually, the Fed was forced to raise interest rates to tame the risk of inflation and stop the massacre in the bond markets.

Fast-forward to 2022. Mr. Carville still loves his LSU Tigers – and the bond market still works the same way. Two years ago, the COVID pandemic caused a brief recession, followed by government deficit spending and a reduction in rates by the Fed.  Now that the economy has come out of that recession, inflation fears have reemerged with a vengeance, and bond prices have fallen in response. Bonds are “exciting” again for the first time since Forrest Gump was in movie theaters, so now is a good time to understand why bond prices tend to fall in the face of inflation, and what the relevant risks are.

An Inflationary Tale

When inflation expectations increase, interest rates tend to increase as well because investors demand a higher return to keep pace with inflation. This increase in interest rates, however, tends to result in a decrease in bond prices.

But why? Consider the following: If the prevailing interest rate for a 10-year US Treasury bond is 5% and you own a 10-year US Treasury bond paying 5%, you will have no problem selling that bond for full face value. If, however, the prevailing rate of interest rises to 6%, you will want to sell your 5% bond and buy a new one paying 6%. But no one will want to buy your 5% bond, given the availability of the 6% bond. In order to sell your bond, you will have to lower the price below the stated face value, and the more years your bond has until maturity, the more you will need to discount the price.

A Bit Of Perspective

This year’s rise in interest rates shows that bonds, which tend to carry much less risk than do stocks, can still lose money, especially in the short term. The first three months of 2022 saw the Bloomberg US Aggregate Bond Index decrease by 5.9%, which is the worst quarter for the US bond market in more than 40 years.

But let’s put this in perspective: Although a 5.9% loss is the biggest quarterly decline for bonds in a generation, the US stock market has had quarterly losses of at least that magnitude 21 times since 1980. In addition, this “dramatic” drawdown in bond prices could actually signal much brighter days ahead for bond investors.

A Brighter Future

The bond market’s periods of intimidation are often followed by kinder, gentler times. Unlike stocks, bonds have a maturity date, at which time the bondholder receives the full principal value of the bond from the bond issuer (assuming the issuer is solvent), regardless of what interest rates have done in the interim. This means that the losses that a bond’s price endures as interest rates rise are gradually eliminated as the bond reaches maturity. It also means that after a bond falls in price, the future rate of return on the bond (the yield) must increase in order for the bond’s price to “catch up” to its full face value at maturity.