Why Bonds Affect Everything

Commentary

Professional market watchers obsess about bond yields and central bank interest rate policy far more than the general public. Even retail stockbrokers and sales personnel who have successfully rebranded themselves as “portfolio managers” don’t give bonds the attention they deserve. Understanding interest rates is not simple, and stockbrokers can often earn higher margins on stocks than on fixed income products.

Individual investors should be aware that bond yields profoundly affect them. This is even true if their retirement funds are 100 percent invested in stocks.

Government bond yields are crucial to understand, since they are the benchmarks for other interest rate instruments. When government bond yields rise or fall, other rates are affected, including for money borrowed by large corporations or small businesses.

U.S. Treasurys are risk-free, or at least as close as we can get to risk-free, in terms of creditworthiness, so everything with respect to interest rates is affected by bond yields. After all, rational investors would not accept less interest for an asset with higher credit risk than instruments issued by the U.S. Treasury.

Mortgage rates are crucial to homeowners. Low mortgage rates between 2008 and 2022 favored homeowners. However, this also caused home prices to spike and reduced affordability. Higher rates and higher home prices are making it difficult for an entire generation to enter the housing market.

The U.S. is a giant economy, and the dollar is the world’s reserve currency and primary trading unit. Importantly, the U.S. Treasury can print as much money as it needs to fulfill its bond and money market payment obligations. History teaches us that money printing in order to fulfill a government’s payment obligations when tax collection falls short, if it goes on too long, eventually causes bond buyers to no longer have confidence in the government. This eventually results in serious problems. However, corporations and individuals do not have this option of printing money.

The most obvious way bond yields affect ordinary investors is through the bond yields themselves and interest rate volatility. All things being equal, the higher the yield, the better for investors who hold bonds. However, there is a huge caveat to this statement. Over the long run, the absolute level of bond yields is far less important than the rate of interest paid relative to inflation. When bonds are purchased at yields in excess of inflation, the investor thrives. We had an unprecedented period of high real bond returns in the aftermath of the early 1980s, when Fed Chairman Paul Volker allowed rates to rise enough to break the back of chronic inflation. In September 1981, the yield of 30-year U.S. Treasurys hit 15 percent. By 1983, inflation hit 3 percent and was really never above 5 percent for any significant amount of time until the post-COVID bump.

The period leading up to the early 1980s, beginning in the mid-1960s, was a brutal time for bond investors and retirees who relied on bonds to fund their daily needs. Yields were high, but inflation rose and always seemed to rise above market expectations. The period after the Great Financial Crisis of 2008 and its subsequent period of historically unprecedented low rates was also not a good period for bond investors. Inflation was low, but rates were also low. This period culminated in an absolutely brutal bear market in bonds that saw long government bond yields rise to 5 percent in October 2023 from 1 percent in March 2022, resulting in a price drop of more than 30 percent.

Even large corporations and, by extension, investors hold stocks that are affected by bond yields. Corporate profits decline as companies’ borrowing costs rise, as interest expenses may be a significant cost for levered companies. Rising interest rates are especially an issue in the private debt and equity markets. Although those firms do not trade publicly, a credit crisis would metastasize into problems for the entire economy.

Many firms, due to low rates and a low cost of capital, invested in projects and businesses that would not be viable during most periods when interest rates were not at all-time lows. The era of low rates is over, and this will curtail investments in marginal projects and businesses. That is not necessarily a bad thing, as low rates created much malinvestment. However, no one should rely on interest rates returning to historic lows anytime soon.

Bonds compete with equities. Low rates made equities far more attractive than bonds. However, with price-to-earnings ratios near all-time highs and 10-year U.S. Treasury yields rising to 4 percent from 1 percent, the value propositions of bonds have improved relative to stocks. Income from bonds and even dividends has become more important. Older investors, especially, need to consider this, unless they are to suffer the fate of investors in the 1930s and 1970s.

The views and opinions expressed are those of the authors. They are meant for general informational purposes only and should not be construed or interpreted as a recommendation or solicitation. The Epoch Times does not provide investment, tax, legal, financial planning, estate planning, or any other personal finance advice. The Epoch Times holds no liability for the accuracy or timeliness of the information provided.

Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.