Over the past year, we have seen significant decreases in both the stock and bond market. One of the big culprits is inflation. A significant spike in the prices of the things we buy every day prompted a big increase in interest rates. The rising rates have created poor returns for bonds. While we can't "undo" the damage, there is a reason to be optimistic. Today we discuss the silver lining of higher interest rates.
Watch Now: The Silver Lining of Higher Interest Rates
- 0:00 Intro
- 0:26 Welcome
- 0:54 The silver lining of higher interest rates
- 2:15 It's easier to hold cash
- 2:56 The impact on future returns
- 4:04 Higher rates can help you reduce risk
- 4:51 What if the Federal Reserve cuts rates in the future?
- 6:31 Final thoughts: An exciting opportunity for the future.
- 8:08 Final thoughts: A better opportunity for managing your cash reserves.
- 8:53 Outro
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Bonds are Math
Bonds are fairly simple to understand. They are a loan between two parties. They have three main components: Their coupon (interest rate), their price, and their maturity (how long the loan lasts). Those elements combine in a mathematical formula to determine a bond's yield. The yield is the return an investor will earn if he or she holds the bond until maturity. Bonds are sold on a yield basis.
Here is a simple example: If you buy a 5-year bond with a 4.5% yield and hold it for five years, you will earn 4.5% on your investment.
Yields have Increased Significantly
Over the past 12-15 months, yields in the bond market have increased significantly, especially for shorter-term notes. And this has created better opportunities for your cash reserves.
Holding cash is an important part of a financial plan. But until recently the incentives to keep money in savings accounts, money market funds or CD's have been frustrating. More recently, we have seen that situation improve to where returns on these types of accounts are far more attractive.
The Impact on Future Returns
Last October, we talked about how lower future returns could affect your retirement. At the time, the stock market was near all-time highs and the valuations pointed to a risky situation. The yields on the bond market were around 2%. It is
difficult impossible to predict future stock market returns. But predicting future bond market returns are a little more straightforward.
The yield on the bond investments you have in your accounts is a reasonable estimate of what you can expect to earn from those positions in the future. It won't be exact, but it should be close. If the yield on your bond investments is 4.5%, that is the return we would expect over the next few years.
Higher Yields Can Reduce Risk
In a lower-yield environment, it was difficult to find sources of return. In some cases, it may have meant allocating more to other riskier asset classes (like stocks) to generate a reasonable return. Doing so means you expose yourself to the possibility of bigger declines in bear markets like 2022.
Being able to earn higher yields means you won't have to look to other more volatile assets to generate better returns going forward.
What Happens if Interest Rates Fall?
Interest rates and bond prices move in opposite directions. When one goes up, the other falls.
With the significant increase in interest rates and yields over the past fifteen months, we have seen bond prices fall. One of the most fundamental rules is to buy low and sell high. Bonds are attractively priced today, and they may see further decreases as interest rates continue climbing.
Most people believe at some point, the federal reserve will have to reverse course and begin reducing interest rates in the future. This would mean bond prices would increase.
It is hard to think of bonds as fun or sexy. But right now, this is an exciting time to look at the future potential of these investments. Higher yields mean better opportunities for both your longer and shorter-term savings. It is worth a conversation, and if you would like to reach out to one of our advisors, fill out the form below.
Appearing in this Video
Daniel Spurgeon, CFP®Dan is a CFP® Pro in our Parkersburg office. He began his career as a financial advisor in 2013. Dan and his Wife Sara recently welcomed their third child into the world.
Neal Watson, CFP®
Neal has been a financial advisor since 1996 and earned his CFP® designation in 1999. He is located in Marietta, Ohio.