Continuing the recent series about monetary easing and fiscal stimulus, let’s now take a closer look at the specific impacts of these policies on the bond market. First, it is important to revisit the investment basics of bonds, as debt instruments, and how they differ from stocks, which represent an equity stake in a company.
Like any kind of debt, bonds have a lender and borrower component. The borrower can be a corporation, local municipality or a larger government entity. The lender is the investor. When a bond is created, the borrower issues debt that an investor purchases, usually securities issued in $1,000 or $100 “par” increments and a stated interest rate that is usually based on the creditworthiness of the borrower. If held to maturity, the lender’s investment in the bond matures at par, having earned the interest from the borrower during the life of the loan.
The higher the risks with the issuing entity, the higher the interest rate or coupon, much like a home mortgage loan rate that is based on a person’s credit score. That is why United States Treasuries are viewed as the lowest risk bonds and have lower interest rates, sometimes referred to as the “risk-free-rate”. Conversely, certain highly leveraged and financially stressed borrowers must pay a higher yield, or interest rate, to incentivize lenders to take on the higher risk of lending them money. “High-Yield” or “Junk-Bond” is a term that is sometimes used to describe these tranches of lower quality and higher risk issuers. As the issuer’s financial stability and credit-worthiness changes during the life of the bond, the value of that bond may also change as investor’s risk of not being repaid at par up on maturity increases. That is the “credit risk” component of a bond, but bond investors are also faced with interest rate risks.
During a rising interest rate environment, where the “risk-free” rate is increasing, debt that is previously issued becomes less valuable to an investor or lender because they can usually get higher coupon rates from new borrowers of the same creditworthiness. As interest rates rise, the value of previously issued bonds decreases due to this inverse relationship. Since the early 1980s, we have seen a decades long decline in interest rates, which has boosted the value and total return of bond investments.
This decades long decline has been a positive for bond investors seeking total return, but savers that rely on bonds for fixed income are challenged. Finance personalities like Tom Keene refer to this as a form of “financial-repression”. There is also a building chorus of voices that point to the long-term risks to growth associated with an artificially manufactured low-interest rate environment. Given the recent dynamics and increases in the stock-buyback policies of some publicly traded companies, it is not hard to imagine the rationale of a corporate finance executive issuing a bond at a low rate and utilizing those funds for a stock buyback program that could generate a higher net rate based on the performance of the company stock, rather than investing in the future expansion and growth of the company.
The argument also exists that if left to its own free-market dynamics, the bond market would place higher yields to zombie like companies that would otherwise go bankrupt if it were not for the support of and access to specialized lending facilities. This brings us back to the beginning of my series long coverage surrounding the unprecedented monetary action that the Fed has undertaken during the past several years and accelerated during the pandemic. The reversal of the monetary tightening policy in late 2018, coinciding with the sell-off that was ensuing the bond market at that time, coupled with the corporate and treasury repurchase (Repo) facilities during the past year has created an environment where bond issuance has continued to balloon and fiscal debt continues to expand.
It is hard to imagine how rates could possibly increase in the future, given the amount of debt that would be at risk of decreasing in value. There will be no easy answer, but much like our personal investments and related decisions from time to time, a rebalance is certainly needed.
~Shar Gogerdchi, CFP®