For me, when we look back at the first quarter of 2021 one thing really stands out. It wasn’t that small cap stocks nearly doubled the overall market. Nor was it the fact that value stocks finally got their time in the spotlight. I thought the most interesting fact was that the Barclays Aggregate Bond Index was down 3.5%. That might not sound like a lot, but it is the worst 3-month period for the index since 2004. To understand why this has occurred we must recall one of the most consistent trends observed in finance: when interest rates rise, bond prices fall.
Imagine that we are sharing a meal and I began bragging about my new Rhode Island municipal bond. I point out that the reason I purchased this IOU from the smallest state in the union is that it is paying me 5% interest per year. You are impressed! In fact, you are so impressed that you go right down to the Treasurer’s office in Providence and ask to buy some RI debt for yourself. As it turns out the 5% bonds are no longer available. However, you can purchase a 5.5% bond for the same price. Wonderful! (Why the rate has increased can vary but is not important for this lesson). After you have purchased your new bond, you run into me on the street and begin boasting yourself. Suddenly my bond does not appear to be all that great. If I try to sell my bond on the open market, I will have to sell it for less than I paid for it because the state is now paying a higher rate of interest.
In the investment world this is known as interest rate risk. At the beginning of the year the rate on the 10-year US treasury was 0.94%, that increased to 1.75% by the end of the quarter. 1.75% is still relatively low for the 10-year but an increase of 86% over three months is not, and the bond market reacted predictably.
Bonds are at once the most and least interesting of all the investments out there. Very rarely do they make headlines but the overall effects the bond market can have on the economy are gargantuan. They are also extremely important to a moderate investor who is seeking not just growth from a portfolio but income and stability as well. I expect interest rates to move higher in the coming years making the job of managing a bond portfolio difficult, but not all bonds are created equally, and some do better in this type of environment than others. Be sure to talk with your financial professional to see if your portfolio is ready for the challenge that lies ahead.