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Three Myths About The Bond Market
The era of declining interest rates may have come to an end , and many investors don ’ t seem to realize it .
By Allison Schrager
FOR THE LAST 40 YEARS , INTEREST RATES have gone pretty much one way : down . In the last 18 months , however , rates have crept up , and many are worried they will stay high . In other words : Reality is catching up with the bond market — and with the myths that have grown up around it . Here are three of those myths .
Myth 1 : Safe bonds are also risk-free bonds . The “ risk-free asset ” appears in asset-pricing models and is considered the barometer of risk for the entire market . But what exactly “ risk-free ” means is not so obvious . It ’ s not the case that anything which has a low probability of default — U . S . Treasury bonds , for example — is risk-free . When yields were low , investing in a 10- , 30- , or even 50-year bond seemed like a free lunch , a bit of extra yield at low risk .
Not true . A longer duration means greater price volatility when rates change . Longer-term bonds aren ’ t actually riskless .
What about a three-month Treasury bond ? It ’ s liquid , and its value is not so sensitive to changes in interest rates . And it might be a good option if you want to ensure that the nominal value of your portfolio does not change much ( inflation is another story ). But a three-month Treasury is not riskless either .
Say you are managing a pension fund , or just saving for retirement . You are financing a liability that will come due in decades . The market value of that liability is based on longterm rates , too , because it is discounted using the yield curve . So if you want to ensure you have enough money to pay pensions ( or just yourself ), a 20- or even 50-year bond is riskfree because its price changes offset changes in your liability .
A three-month bill leaves you exposed to inflation risk , or just varying interest rates .
As an example , consider the Austrian 100-year bond . It has fallen 60 % in the last five years , down 16 % in just the last year . But if you have a pension fund that has the same duration , the cost of your liability also fell 60 %. Matching duration is a valuable hedge when rates are volatile and unpredictable .
Myth 2 : Federal Reserve policy determines long-term interest rates . In theory , longer-term bonds — say , 10 years and beyond — are based on expectations of future short-term bonds . If you kept buying a series of three-month Treasury bills for a decade , it should replicate a 10-year bond .
It then follows that if people expect the Fed to cut rates in the future , long-term rates should be lower than short-term ones — as is the case today . The belief that the Fed is serious about higher rates for longer helps explain why rates are creeping up now . Alternatively , bulls argue that longer-term rates will go back down when the Fed does start to cut in response to the inevitable recession .
But the evidence is pretty weak that the Fed ’ s short-term rate interference has much influence on longer-term rates . It may for
NOVEMBER 2023 | FINANCIAL ADVISOR MAGAZINE | 39