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Despite a late sell off by stocks, the second quarter of the year produced positive returns for the stock market.  The bond market, however, concerned that economic stimulus by the Federal Reserve may be coming to an end, sold off as interest rates jumped.

Many investors are concerned about seeing negative returns in their bond portfolios.  While we never like to see negative numbers on our performance reports, bonds fluctuate in value just like all other financial assets.  We have gotten very accustomed to seeing nothing but gains from the bond market over the years as interest rates have dropped to near zero.  As interest rates move back to a more normal level, bond prices will drop.  When prices drop by more than the bond’s interest rate, you get negative returns.

The inverse relationship between interest rates and bond prices is mysterious to many people so we thought we would provide an explanation to help make it clearer.  As an example, imagine you have a choice between two bonds with the same credit rating and maturity.  One bond pays 6% and the other pays 2%.  You would clearly want the 6% bond over the 2% bond.  This makes it more valuable and you would have to pay more for this bond.  If, after a year, interest rates have risen to 8% for the same bond, you would need to lower the price of your bond if you wanted to sell it because the bond buyer would rather own an 8% bond than your 6% bond.  To make it worth it to the new buyer, you would need to drop the price of your bond to where it equals the yield to maturity of the higher paying bond.  The opposite is true if interest rates drop.  Your bond becomes more valuable than those with a lower interest rate.
All of this explains how our bond portfolios have averaged 6 ½% returns over the past few years when interest rates are near zero.  Bond prices have risen as interest rates have dropped, giving us outstanding returns.  In fact, interest rates have been dropping for more than thirty years since they peaked in 1981.  From current rates, it is difficult to imagine rates continuing to drop, so it is almost a certainty that bonds will underperform their numbers in the future from the past thirty years or so.  

It is important to remember that all of this does not mean you should sell all of your bonds and buy stocks.  A bad year in bonds is much better than a bad year in stocks.  Bonds still provide the stable part of a portfolio and will continue to do so in the future.  As always please call us if you would like to review your bond portfolio and discuss our market expectations in more detail.

About Wabash Capital

Wabash Capital is an employee-owned registered investment advisor based in Terre Haute, Indiana, providing investment advice and professional portfolio management to individuals, corporations, banks, trusts, retirement plans and endowments. To learn more about our business, please visit www.wabashcapital.com.