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A Bond Market Bubble in the Making?

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Since the Great Recession of 2008, the Federal Reserve reduced, and then held, short-term interest rates at virtually 0% in an attempt to combat a global financial crisis and stimulate the U.S. economy.

This action also enabled the government and consumers to borrow as cheaply as possible — at the expense of lenders, investors and savers. Retirees relying on fixed-income interest payments from Social Security, bonds and bank CDs have effectively been short-changed to the benefit of borrowers.

The U.S. economy, no longer in crisis mode, has been experiencing steady, consistent low-to-moderate growth. As the economy becomes healthier, it becomes necessary and desired for the Federal Reserve to begin to raise interest rates gradually, toward a more normal, long-term economically “neutral” level of perhaps 3.50%. This will enable the Fed to lower interest rates again in the future, when needed, to stimulate the economy to avert the next inevitable recession.

Long Term Rates

Unlike short-term interest rates, long-term interest rates are not controlled by Federal Reserve policy. The impact of supply and demand forces on the capital markets sets long-term interest rates daily.

The present yield curve is steep by historical standards, indicating the expectation that short-term interest rates will rise by about 1% during the next 12 months. Long-term rates are generally expected to remain relatively more stable.

Long-term interest rates are most influenced by future expectations for inflation. Inflation is currently projected by the bond market to be less than 2% per year during the next 30 years. (It should be emphasized that it is futile to predict interest rate changes with any degree of certainty.)

Bonds can effectively be used to diversify a portfolio, reduce risk and actually enhance returns under volatile stock market conditions. When interest rates rise, however, the prices of existing, lower-yielding bonds fall because investors can simply purchase newly-issued bonds at higher, current interest rates.

The Bond Market

Duration is the mathematical calculation that is used to measure the price volatility of a bond. A higher duration signifies potentially greater price volatility. Longer-term bonds generally have a higher duration, as can be seen in the table below using data from Vanguard (as of Sept. 30).

For every 1.00% change in interest rates, a bond can be expected to experience a capital gain or loss roughly equivalent to its duration.

For example, if interest rates increase by 1.00%, a short-term bond may lose about 2.70% of its value, while a long-term bond may lose nearly 15% of its value. The capital losses on both types of bonds, however, will be offset somewhat by the higher interest income. Unless the bonds default, interest still will be earned.

Interest rate increases that are gradual and anticipated are a positive sign for the economy and should not necessarily be expected to rattle the bond market. During periods of rising interest rates, it is best to minimize exposure to longer-term bonds, keep bond duration very short and look forward to earning a higher interest rate on savings.

Christopher Parr, CFP, is president of Parr Financial Solutions, of Columbia. He can be reached at 410-740-9011 and via www.ParrFinancialSolutions.com.