Good Employment News Was Bad News for Investors
In a counter-intuitive case of “good news is bad news” the bond and (in turn) stock markets both reacted negatively to an employment report that showed the economy humming along on all cylinders. Job growth continues to be strong, the unemployment rate is at a FORTY YEAR LOW. One would think that with an economy so strong, markets would be jumping for joy, right?
Instead, the market interpreted the news as indication that a hot economy means inflation (while still tame) may be just over the horizon, and that interest rates would have to move higher. So they did. Interest rates on the US 10 Year Treasury jumped to almost 3.25%, after having been hanging around or just under 3% for much of the year. In bond market terms, that is a big jump for just one week. Remembering that bond prices move opposite to interest rates, higher rates meant lower prices for bonds. The Vanguard Total Bond Market Index ETF (BND) was down almost 1% in just 3 days between Oct 2 and Oct 5. That’s a really big move for the normally sleepy bond market.
The idea of higher interest rates were not very well received by the stock market either. Again, despite a good job report that should have sent stocks higher in anticipation of continued robust growth, the market reacted negatively. The Vanguard Total World Stock ETF was down about 2.1% last week.
Building a Case for Bond Investments. With interest rates apparently heading higher (for now anyway) I get a lot of questions about why one invests in bonds. After all, if bonds lose value when interest rates go up, why not stay away?
There are several reasons to maintain your asset allocation, even in the face of higher interest rates. Foremost among them is the truth that when a bond loses value, it is not like a stock losing money. When a stock loses money, you really have no idea when it will recover. With a bond, however, you know with certainty, as long as the issuer isn’t bankrupt, that a bond on its maturity date will be worth its face value. The price of the bond will move closer and closer to the face value as the bond gets closer to maturity. In effect then, recovery of bond losses is just a matter of time – waiting for bonds to mature – at which point, they can be reinvested in bonds with higher interest rates, which means more income for the portfolio. IN THE LONG RUN then, higher interest rates are good for bond investors. After all – the primary reason you invest in bonds is income – either to spin off and spend, or to reinvest and buy more bonds!
The next important reason to maintain your allocation to bonds when interest rates are heading higher is – maybe they won’t! We don’t know with certainty what markets will do, and that goes for bonds and interest rates as well as stocks. We hold bonds to DIVERSIFY - so that if our stock investments go to hell, we have something more stable to support our portfolio. If economic growth stalls, or there is geopolitical turmoil upsetting the markets, demand for safer bonds will likely soar, interest rates will fall and bonds will rally. That can be powerful medicine for a portfolio which is being decimated by falling stock prices. In 2008, high quality bonds were the only investment that managed to turn in positive returns. The Boy Scout motto applies – Be Prepared. Unless you are able to handle the risk of a 100% stock portfolio, some allocation to bonds makes sense.
Today the stock market returned to stability – but the bond market was closed for Columbus Day holiday. We will be watching closely to see what happens tomorrow.