Over the last year-and-a-half, we’ve been witnessing the highest rates of inflation both globally and domestically seen since the early 1980s. While it’s debatable as to whether this rampant inflation has been due to supply disruptions since the Covid-era, excessive government spending or a ramp-up in economic growth from artificially low interest rates, higher prices are everywhere: Used cars, airline tickets, dining out, gasoline and even eggs have seen substantial, even drastic price increases.
While stretching consumer wallets, these elevated inflation figures have yet to bring down consumer spending significantly enough to reduce economic growth: employment levels remain particularly strong and GDP growth has yet to experience any significant decline. As a result, domestically, the US Federal Reserve has been on a mission to tame these inflation rates by using one of the tools it has in its arsenal: the Federal Funds Rate.
The Federal Funds Rate is the interest rate the Federal Reserve charges banks to lend money to each other in order to shore up their regulated reserve requirements. This rate has been increased 11 consecutive times since early 2022 and appears to be having a pronounced effect on bringing down inflation: recent figures as of Wednesday, September 13th has core inflation (which does not include volatile food and energy costs) down to 3.7% on a year-over-year annual basis, versus the 9.1% figure we saw in July of 2022.
It appears that in the US, the central bank is not yet finished its rate increasing campaign: the interest rate futures market (Fed Fund Futures) has market participants pricing in another rate increase in December. Even investment bank behemoth Goldman Sachs is now indicating interest rates may stay elevated until the fourth quarter of 2024, rather than beginning their decline early next year, as was predicted this spring.
However, at some point over the next year, the consensus view amongst most interest rate prognosticators on Wall Street is that short-term rates (which are influenced by the Federal Reserve) will likely come to a halt and perhaps even begin their descent. Furthermore, if economic activity is stymied enough and a recession potentially occurs, long-term rates (as seen in the Treasury bond market) should start coming down as well.
As most individuals know, through the concepts of present value, duration and convexity, bond prices increase when interest rates are falling. More often than not, this typically occurs during the contraction phase of the economic cycle (a recession). This mathematical concept is a given in the government Treasury bond market and even in the high-grade corporate bond market. As such, many portfolio managers feel that now is a great time to begin building a position in these two fixed-income markets in order to take advantage of falling rates which may occur over the next year when the economy begins to slow or even enters a recession.
However, we’re going to take a look at the bond market from a different angle: What bonds, in theory, don’t do as well when interest rates decrease, and therefore may be a good idea to underweight in your portfolio. The first thing to remember is that the bond market is huge and heterogeneous. Huge meaning that bonds surpass stocks in terms of their global market value by a multiple of 3. Heterogeneous meaning that all bonds are not created equal: they have different terms to maturity, different credit risks, different issuers, different default rates, different term premiums and may have certain features (ex. options) that make bond markets different.
The first bond sector that often doesn’t do well when interest rates are on the decline are known as ‘high yield’ (also called ‘junk’ or ‘below investment grade’) bonds. High yield bonds are issued by corporations with higher credit risk. High credit risk indicates that if the economy falters and a firm’s business conditions decline, the company will likely have a much more difficult time making timely interest (coupon) payments to investors, causing the value of their bond principles to decline.
This is what is unique in the high yield bond arena: high yield bonds are much more sensitive to credit risks (or credit spread risk) rather than interest rates fluctuations. High yield bonds often zig when Treasury or investment grade bonds zag. When interest rates are declining (likely next year), the economy is usually near the bottom of its cycle, often the contraction (recessionary) stage.
High yield bonds are not as sensitive to interest rate declines as they are to the general stage of the economic cycle, like a common stock: They are much more sensitive (40 times as much) to changes in credit spreads, and therefore, economic conditions than high-credit bonds. This is why they should be reduced in your portfolio now, because if a recession ensues next year, prices of high yield bonds could be decimated.
Bonds that are known as ‘securitized’ are another area to decrease exposure to when interest rates are on the way down. Securitized bonds hold debt in pools of income-generating assets, and are then backed by that same underlying asset. Some examples of securitized debt are mortgage-backed securities, credit card receivables, automobile loans and student loans. While this may sound like a broad swath of bonds, these securitized bonds tend to behave in a similar fashion when interest rates are on the move.
Similar to other bonds, securitized bonds also have duration measures, that is, their sensitivity to interest rate movements. When compared to US Treasury Bonds and investment grade corporate bonds, durations of securitized bonds tends to be significantly lower. Furthermore, like high yield bonds, these securitized bonds tend to have more sensitivity to the principal and interest payments on the underlying liabilities (credit risk) vs actual interest rate movements. As a result, if we experience a recession next year and the actual owners of these debts have difficulty in making their payments, its likely that these bonds will experience a decrease in value.
Another bond to generally avoid when interest rates are trending lower are what are known as callable bonds. Callable bonds, issued by corporations, give the corporation the right to purchase the bond back from the holder should interest rates decline. Essentially this means that this callable feature gives the corporation the option of buying the bond back from the holder, retiring the bond and then issuing new debt at lower rates, saving the firm money. This can be a big financing advantage for corporations when interest rates decline significantly.
Adversely, this can be a big disadvantage for investors in callable bonds in declining interest rate environments. Callable bonds are issued with higher coupons to compensate or even lure investors in the event that interest rates do decline and the corporation buys the bond back. If interest rates drop and the bond is called, the investor loses this higher coupon payment that they were expecting for the life of the bond and is then forced to look elsewhere for income return (and a higher principal payment in the future). Furthermore, many callable bonds are found in the junk or below-investment grade status area, and as we discussed earlier with junk bonds, they have lower interest rate risk.
Floating rate bonds are another bond sector to be cautious of when interest rates begin their descent. These products are essentially loans that banks make to below-investment grade status corporations (similar to high yield we discussed earlier) where the interest rate fluctuates with prevailing rates.
Floating rate bonds carry substantial credit risk. If the economy begins to deteriorate and a recession ensues, the underlying businesses with the floating rates loans may have difficulty making their interest payments, resulting in defaults, causing the prices of the underlying bonds to decline. Furthermore, they carry a floating rate and by this nature have much lower interest rate sensitivity (duration) when rates do begin to decline. As such, if rates drop as many feel may occur next year, they may not experience as much of an increase in price as other types of bonds.