Are Bonds a Good Investment Now? Fed Interest Rate Hike Expected – Buy or Sell Bonds?

By Ogbe Airiodion . Updated | July 27, 2015 5:36 pm

 

Yellen - Fed interest rate hike expected. Should Investors invest in bonds now or sell

Are Bonds a Good Investment Now? Fed to Raise Interest Rates

Now that the US Fed is set to raise interest rates, are bonds still a good investment?

On Wednesday, July 15, 2015, Janet Yellen, Chair of the US Federal Reserve, told members of Congress that the Fed will be raising interest rates before the end of 2015.

Over the last year, investors have grappled with the possibility of the Fed raising interest rates and the impact that an interest rate hike would have on bond investments.

Key questions asked by investors have included, “Are bonds a good investment when the Fed raises interest rates?” “When will the next interest rate hike be?” and, “Will the Fed raise interest rates this year?”

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Investing in Bonds Based on Interest Rate Predictions

Major Wall Street firms, as well as institutional investors (hedge funds, trading firms, mutual funds, etc.), maintain highly complex and comprehensive financial models that estimate bond values and predict whether bonds are a good investment at various points in time.

A key variable in their bond valuations are Fed interest rate predictions.

In essence, financial models do not only consider current rates, they also consider future interest rate hikes with regard to the buying and selling of bonds.

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The nature of being a bond investor (or any type of investor) is that you have to always look ahead (far ahead), at every point in time, when you are evaluating whether bonds are a good investment.

So, even if the Fed was to raise interest rates today, institutional bond investors would basically take the new interest rate figure, plug that number into their financial models, and immediately start looking ahead for when the next interest rate hike will come.

The goal is to always be one step ahead of the market.

However, if you are an individual investor (or just someone that is interested in buying bonds), how do you determine whether bonds are a good investment now? How do you perform interest rate predictions to effectively compete with hedge funds, mutual funds, and institutional bond investors?

investing in bonds - buy bonds or sell bonds.

 

Are Bonds a Good Investment Now or Should You Sell Your Bond Holdings?

To determine whether to invest in bonds now, there are a couple of variables you should consider, in addition to learning how to effectively conduct interest rate predictions.

Key variables to consider include:

  1. Bond yield (how much total return you can expect to get from buying a bond)
  2. Bond rate (the stated bond rate determines the coupon amount that is paid out periodically)
  3. Bond prices (present-day value of the bond if you sell or buy the bond today)
  4. Fed interest rate outlook and predictions (impacts the bond yield)
  5. Market outlook (impacts the bond price)

Bond Yields and Their Correlation with Fed Interest Rates

Bond yields have a direct correlation with Fed interest rates and the outlook on future interest rate hikes.

The reason why the outlook on rates (interest rate predictions) is very important is that investors do not wait for the Fed to raise rates before they decide whether to buy bonds or sell a bond they already own.

As mentioned above, being a bond investor requires you to always be proactive and stay one step ahead of the bond investing pack.

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Waiting until the Fed raises interest rates before you act will be acting too late.

It is akin to closing/locking the barn door after the horses have already escaped from the barn.

Looking at the chart below, you can see that bond investors don’t wait for the Fed to act.

Starting in February of 2015, they are already taking action by bidding up 10-yr and 30-yr bond yields.

Across financial markets, the below situation where yields are rising based on interest rate predictions is referred to as "making a bet on the interest rate outlook."

US government 10-yr and 30-yr bond yields - charts

The same 2015-rise in yields can also be noticed when looking at the 5-yr US government bond chart. However, the effect is more pronounced, with longer-term bonds based on the time factor.

As interest rates rise, longer-term bonds lose more value than shorter maturity bonds.

Why do bond investors bid up bond yields based on the interest rate outlook?

To better understand the process above, we need to take a step back and quickly discuss bond valuations.

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Bonds Pricing – Interest Rate Impact

The price you would pay to buy a bond today (also known as the bond’s present value) is based on the bond’s coupon payments, the number of overall payments, and the bond’s maturity value…

…all discounted to the present-day based on a set interest rate.

Calculating bond prices

The bond yield (i) used to discount a bond to its present-day value (what the bond is selling for today) is impacted by the future outlook on rates.

In order for a bond to remain competitive as an investment vehicle, the yield on that bond needs to be attractive enough to make investors want to buy the bond.

As such, when bond investors expect Fed interest rates to rise, they start requiring (bidding up) higher bond yields today.

The opposite holds true when investors expect rates to fall.

The above happens because of how investors derive the present value (PV) of a bond investment: the sum total of all future payments discounted by a constantly changing bond yield (i).

 

Should You Buy/Sell Today – Are Bonds a Good Investment Right Now?

So, back to the questions: Are bonds a good investment now? Should you sell any bonds you currently have? Or should you buy bonds?

The best answer to all of these questions is, “It depends.”

If you want to invest in bonds with the expectation that bond prices will go up (allowing you to earn a return on the capital gains), then bonds might not be a good investment right now.

As seen above, bond yields are going up.

This increase in bond yields is expected to continue into the future as the Fed executes its interest rate hikes.

This means that bond prices will only continue to drop, resulting in limited opportunities to make a capital gain - selling your bonds at a higher price than what you paid for it.

In this case, it may be time to sell some of your bond holdings (if you have any) and rotate the money into other investments – like dividend paying or high-growth stocks.

As mentioned above, bond prices drop when yields go up, and below are two illustrative charts that show this relationship.

Bond prices and yields - invest in bonds now?

 

Should I invest in bonds based on Fed interest rates

On the other hand, if you believe the US economy is still struggling and that this situation will force the Fed to hold off on raising rates, then selling your bonds now may be premature.

In such a situation, bonds might remain a good investment for you.

In either case, the trick is to always hold a diversified portfolio.

From a portfolio diversification perspective, bonds will always hold a valuable place in any portfolio and will always be a good investment.

Just exactly how much weight should bonds have in any portfolio?

This depends on your individual investment circumstances as well as in the (rising or declining) trends of interest rates.

 

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I’m looking forward to hearing from you.

Cheers,

Ogbe Airiodion

Ogbe has 15+ years of experience supporting top Wall Street firms (Goldman Sachs, Citi, HSBC, BNYM, etc.) in implementing global transformation and compliance operations.

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