My bad! I was wrong about rising rates and bonds

Originally published CNBC

“I was wrong.”

There are few words strung together that possess such power to free us. In less than a second, we’re able to reconcile the inconsistency between our previous conviction and the apparent truth. Humbling, yes, but also strangely euphoric.

Well, I’ve earned the opportunity to claim said euphoria, as I must confess that I had bought into the most prevalent myth du jour surrounding bond investing. You’ll forgive me, I hope, because this misconception—like all of the most powerful ones—is especially deceptive because it’s grounded in half-truth.

Let’s be quite clear: Rising rates simply do not guarantee negative bond returns.

So the myth is that bonds will lose a ton of money when interest rates rise.

It is absolutely true that bonds and interest rates have an inverse relationship—that when they move, they often do so in opposite directions.

Here’s why: This issuance of bonds is a common way that companies, municipalities, governments and other entities borrow money. They issue new bonds, becoming indebted to bondholders, their new creditors.

Bond issuers pledge to pay a stated rate of interest and to return the investor’s principal upon the maturity of the bond. Let’s say, for example, that General Electric wants to build new jet turbines, and it chooses to finance the project through a new bond issue, offering a 5 percent interest rate for those willing to lend GE money for 10 years.

Let’s say you lend GE $10,000 and collect your 5 percent rate of return in the first year.

At the beginning of the second year, GE starts a new project, requiring a new bond offering. Only now, prevailing interest rates have risen, forcing it to offer 6 percent over the forthcoming decade.

Well, if your neighbor can loan GE $10,000 and receive 6 percent instead of the 5 percent you are receiving, you can see why he surely wouldn’t spend $10,000 to buy your bond that only pays 5 percent. A year later your bond might be worth only $9,500, or even less, as a result of a rise in interest rates.

This is why rising interest rates tend to push down the value of bonds on the open market. The inverse is also true, though. When the whole world was gripped with fear in 2008 and 2009, the proverbial “flight to safety,” when everyone wanted to own the only presumably default-free investment—U.S. Treasurys—the demand for Treasurys rose, forcing the yields down.

Then the Federal Reserve delivered on its promise to maintain lower rates, effectively and unprecedentedly, by “printing money” and buying U.S. debt instruments, creating artificial demand to keep rates down.

As the storyline goes, this is the perfect storm that demands higher rates, and soon. They could spike at any time, we hear, resulting in massive bond losses across the board.

Rise they will and spike they could, but here’s where the rapidly-rising-rates-equals-deep-losses narrative loses steam: It presumes that the highly liquid bond market is unaware of all these factors.

It presumes that none of this anticipation and all the hype—which has actually been building in one form or another since the late 1990s—is baked into today’s prices.

It’s simply not true.

“A significant uptick in interest rates is already built into the pricing,” said my colleague Jared Kizer, director of investment strategy at the BAM Alliance, a collective of more than 140 independent registered investment advisory firms across the U.S.

In fact, Kizer’s models estimate that the market expects one-year Treasurys, four years from now, to pay 12 times what they’re paying today.

“So the only way investors will see prices fall is if rates go up more than expected or quicker than expected,” he said.

Neither Kizer nor I would suggest this means you won’t necessarily lose money on your bonds when interest rates rise, but it does portend that you’re not guaranteed to lose money, and indeed you may not.

As I stated earlier, rising rates do not guarantee negative bond returns.

How, then, could this myth have promulgated so successfully if it’s not entirely true?

Well, Wall Street gets paid to transact. News travels faster when it’s sensationalized. And when we hear something repeatedly from reliable sources, we tend to believe it’s true until presented with stark evidence to the contrary.

At that moment, we have a choice. We can ignore the evidence, temporarily preserving our crumbling rightness, or we can utter those gratifying words: “I was wrong.”

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