In looking at markets, one of the key items to note are something called inflection points or, put simply, the point marking a substantial change in direction. In terms of the yield on the 10 year Treasury note, a dramatic inflection point appears to have occurred on July 24, 2012. This date may have marked the end of a 31 year bull market in bonds when the yield on the 10 year Treasury note hit a depressed and anemic low yield of 1.39%, from a high of 15.84% on September 30, 1981. As of July 5, 2013 the yield hit 2.70%!
In looking at the big picture, interest rates had been falling for over 30 years. Going forward, we will likely be in a rising interest rate environment. J.P. Morgan did an analysis on the relationship between average returns of both corporate bonds and the S & P 500 in different interest rate environments.
Falling Interest Rate Environment – 1982 thru 2012
Corporate Bonds averaged 10.1%, versus the S & P 500 at 11%.
Rising Interest Rate Environment – 1958 thru 1981
Corporate Bonds averaged 3%, versus the S&P at 8.6%.
Many people don’t realize that bonds change in value every day. Interest rates change daily to drive the price of a bond up or down. If a bond pays a coupon of 5% and current interest rates are 2%, the bond will most likely sell at a premium. If a bond pays a 1% coupon and current interest rates are 2%, the bond will most likely sell for a discount. So in general, when interest rates are falling, bond prices are going up increasing the return on bonds.
Additionally, bonds with a longer maturity change in value to a greater degree than shorter maturity bonds when interest rates change. Think of it as a seesaw with longer-term bonds on the ends and shorter terms bonds located closest to the fulcrum. When interest rates change and the seesaw pivots, the long term bond prices will move the most, while the price of shorter term bonds will move less.
The results are worth reflection, in terms of portfolio construction and management, as investors navigate a new interest rate environment they haven’t seen in quite some time.