For years, we’ve preached “stay short-term on your bonds”, but today’s the inflection point where the interest rate risk we’ve worried about is now offset by reinvestment risk. So, what is reinvestment risk?
For the past few years, we’ve preached short-term bonds and inflation-protected bonds. Today, the Vanguard Ultra Short-Term Bond ETF has a forward yield of 5%. That’s tough to beat. The Fed is expected to raise interest rates by a quarter percent within the next 24 hours, so by the time you’re reading this, it may already have happened. There’s an 89% probability. We’re going to assume it’s going to happen.
Yesterday’s trap was long maturity bonds with higher yields. A lot of broker dealers sold a lot of elderly people a lot of long bonds, and they got crucified when interest rates went up. Yes, they continued to get that three, 4% yield, but in return, they watched the value of their bond portfolios drop by 40, 50%. Today is the opposite. It’s short-term bonds with strong yields, and it doesn’t seem intuitive, but you’re going to get killed with reinvestment risk. What is reinvestment risk? It’s the risk that as these bonds mature, the replacement yield will be disappointingly low and you’ll be stuck with that.
To put this in context, just today, one day prior to the Fed raising the rates, bond yields slumped on the 10-year note to 3.46%. They’re coming down. There is a sense that the Fed is being disciplined and that the hikes are working as advertised while also slowing the economy. What is the impact? What is the risk? It’s the loss of future bond returns with no offsetting gain in risk containment.
So, let’s talk strategy. There are four elements. First, match maturities up to and including intermediate bonds. We need short-term bonds for short-term needs, ultra short-term bonds if you need money in less than a year, intermediate bonds for the rest of the portfolio. Let’s lock in these yields. So, why not long bonds? Let’s not overcomplicate this. The longer the maturity, the greater the volatility. You should get more yield for that risk. You don’t get the yield for all sorts of technical reasons, so the juice isn’t worth the squeeze.
Let’s talk scenarios. How can this play out? The first scenario is that interest rate hikes aren’t over. Well, we’re already seeing at this point in the economy and this point in the cycle, even when they raise short-term rates, intermediate and long-term rates are staying steady or even dropping, so that risk isn’t really a risk.
Interest rates stay the same. Okay, that’s great. We’re locking in rates that are sticking. We’ve avoided interest rate risk and we’ve avoided reinvestment rate risk. Intermediate or long rates fall, that’s the Goldilocks scenario. That’s also the most likely scenario over time. Not to pre-pandemic levels, but that fallen interest rate will mean not only have we locked in five, five-plus percent yields, but on top of that, we’ve got capital gains on our bond portfolio. So, what is the risk? Really, it’s almost negligible. Why would I say that?
Studies suggest that in today’s environment, only 5% of the total volatility of a 60/40 bond portfolio, that’s 40% of the portfolio, 5% of the risk, is expected to come from bonds. The bigger risk is being stuck with two to 3% yields almost indefinitely as we get into the slower growth environment that is going to result from having to tap on the brakes to get inflation under control. Now, for our clients, we’re beginning to invoke this new strategy. We’re beginning to protect them from this new risk. If you have any questions, feel free to call me. We wish you the best of investment success.
Paul is the founder and CEO of Avion Wealth, LLC. He leads a team of wealth managers in building and executing financial plans for high net worth individuals and families. Contact Avion Wealth to speak with a financial advisor.