What is the most that you would be willing to pay today for an investment guaranteed to pay you exactly $100 one year from today? $90? $95? $99?
You’d probably start this mental exercise by considering the possible return you could earn on similar investments elsewhere. Other short-term conservative investments such as money markets, CDs, and government bonds have offered a yield in the 5% range this year. We could break out the calculator and do the math to back into a 5% return (assuming this was truly guaranteed) and likely conclude that the most you’d probably be willing to pay would be around $95.25. $4.75 profit on a $95.25 investment equals a 5% return.
This is the math done by bond investors when determining the present value of a fixed payment in the future. The lower the interest rates in the economy, the higher investors are willing to pay for those cash flows. If interest rates were 1% on all similar investments, then you’d probably be happy to pay $98.50 and earn an equivalent return of 1.52%... because it’s better than other alternatives. Likewise, if interest rates in the economy were 10%, then you’d have no reason to pay anywhere above $91 today for that future cash flow.
I know… math isn’t fun…but it drives home an important point. Interest rates in the broad economy have a huge impact on asset values. More specifically, there is a direct relationship between interest rates and bond prices. In 2022, the Federal Reserve increased rates from 0% to 5% (roughly). In doing so, bond investors were forced to re-value their bonds to match the prevailing interest rates in the economy. In other words, no one in their right mind would accept a 2% return when they could buy something identical for a 5% return. Thus, bond prices fell considerably in 2022.
The Federal Reserve has now held interest rates above 5% for more than a year, but the indication is that they plan to begin cutting rates this fall. What impact will that have on asset values?
As we’ve just explained, there is an inverse relationship between bond prices and interest rates: when interest rates rise, bond prices fall, and when interest rates fall, bond prices rise. All else equal, if the Feds begin cutting rates, bonds should appreciate in value. I say “all-else-equal” because it isn’t always so simple and the relationship isn’t always linear. Sometimes long-term bonds rise or fall more than short-term bonds. Sometimes it’s the other way around. And not all bonds behave the same. Government bonds and CDs are more predictable because they don’t have the added risk of default.
Stay with me, but let’s go back to the original hypothetical investment that will pay $100 next year, but let’s add “risk” to the equation. Rather than a guaranteed investment, let’s assume that the investment will only pay $100 so long as Wal-Mart isn’t bankrupt in one year. That’s not a lot of risk, but it’s a consideration. Chances are pretty strong that Wal-Mart isn’t going to be out of business in the next 12 months. Still, we may adjust for risk slightly and only be willing to pay $95 (which would increase our hypothetical return to 5.25%). The extra 0.25% return is an adjustment for the added risk of default. But what if the $100 payment was dependent on a small local restaurant remaining in business? Suddenly investors would demand a much higher return for the added risk. The bond may only be valued at $80 or $60 depending on the perceived risk of default.
The value of any bond is the present value of its future cash flows. These cash flows are discounted at the prevailing interest rate and adjusted for the likelihood that the payments are received. Several factors factor into these adjustments. Still, it’s safe to assume that lower interest rates in the economy will make existing bonds more attractive and drive prices higher.
This chart illustrates investors' expectations for interest rates over the next 24 months.
With interest rates expected to fall, this may be a good time to buy bonds. Franklin Templeton produced a helpful chart to illustrate the historic relationship between declining interest rates and bond prices. The conclusion: bonds could offer stock-like returns over the next year if interest rates decline.
Bonds have posted solid annual returns over each of the past eight cycles of declining interest rates. US Treasury bonds have led the way, averaging an 11% return over the 12 months following the first rate cut. On the other hand, stocks are a bit of a mixed bag.
If interest rate cuts are followed by a recession, then stocks do relatively poorly. If the economy avoids a recession and we get a “soft-landing” then stocks have historically done quite well.
The relationship between interest rates and equities is multifaceted. On one hand, lower interest rates reduce the cost of borrowing for companies, leading to higher capital investment, increased profitability, and potentially higher stock prices. On the other hand, interest rates typically decline because Federal Reserve officials see an elevated risk of an economic slowdown.
The pace of economic growth is the main factor influencing the interest rate decisions for the Feds. Signs of a weaker economy will increase the likelihood of a rate cut in September (the next scheduled meeting for the Federal Reserve).
We believe that the odds are high for a rate cut this autumn. It remains to be seen how stocks investors will balance the risk of a slowing economy, but bond investors should welcome to falling rates. If history is any indicator (and it usually is), then we are approaching the time to shift from floating yields in money markets and saving accounts into fixed-rate bonds that can appreciate in value as rates decline.
Any opinions are those of Brady Raanes and not necessarily those of Raymond James. This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete.
Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Expressions of opinion are as of this date and are subject to change without notice. This information is not intended as a solicitation or an offer to buy or sell any security referred to herein.
Investments mentioned may not be suitable for all investors. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct.
Past performance may not be indicative of future results. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Prior to making an investment decision, please consult with your financial advisor about your individual situation.
Bonds are subject to risk factors including:
1) Default Risk - the risk that the issuer of the bond might default on its obligation
2) Rating Downgrade - the risk that a rating agency lowers a debt issuer’s bond rating
3) Reinvestment Risk - the risk that a bond might mature when interest rates fall, forcing the investor to accept lower rates of interest (this includes the risk of early redemption when a company calls its bonds before maturity)
4) Interest Rate Risk - this is the risk that bond prices tend to fall as interest rates rise.
5) Liquidity Risk - the risk that a creditor may not be able to liquidate the bond before maturity.
If a bond is listed as "insured," the insurance relates only to the prompt payment of principal and interest of the securities in the portfolio. This does not remove market risk. Yield and market value will fluctuate with changes in market conditions. Price and availability are subject to change without notice. Investing involves risk and investors may incur a profit or a loss.
Guaranteed [or insured] bonds are guaranteed [or insured] as to timely payment of principal and interest. Yield and market value will fluctuate with changes in market conditions.
U.S. government bonds and Treasury notes are guaranteed by the U.S. government and, if held to maturity, offer a fixed rate of return and guaranteed principal value. U.S. government bonds are issued and guaranteed as to the timely payment of principal and interest by the federal government. Treasury notes are certificates reflecting intermediate-term (2 - 10 years) obligations of the U.S. government.