Stubborn inflation does not change the bond math Stubborn inflation does not change the bond math\images\insights\article\hand-whiteboard-small.jpg May 21 2024 May 15 2024

Stubborn inflation does not change the bond math

Sticky inflation might slow the Fed, but not the timeliness of extending duration.

Published May 15 2024
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Today’s slightly cooler U.S. inflation report likely won’t give the Federal Reserve enough confidence to cut interest rates soon, but should it postpone the duration extension trade for fixed-income investors?

The annualized Consumer Price Index (CPI) rose 3.4% in April compared to 3.5% in March. The futures market now expects the Fed to deliver as few as one quarter-point reduction of the fed funds target range this year. Investors considering moving assets to bonds might conclude they should put those plans on hold. After all, money market and stable value yields remain north of the Bloomberg Aggregate Bond Index. But while timing the movement in interest rates isn’t any easier than timing the stock market, fixed-income investors have bond math on their side. Let me explain.

Duration is related to the maturity of a bond. The longer it takes to get your principal back, the more sensitive the bond’s price is to changes in interest rates. Bonds with longer maturities will go up in price more than bonds with shorter maturities if rates fall. That’s why many investors wonder if it’s time to extend duration to benefit from a potential decline in interest rates.

Of course, extending duration too early can lead to price depreciation. But with interest rates significantly higher today than they have been for much of the past 15 years, this risk is much more muted than when the federal funds level was lower. For example, in March of 2021, when 5-year Treasury rates were at 0.4%, it only took a tiny increase in rates, from 0.40% to 0.48%, to wipe out an entire year’s worth of income from coupon payments. Today the 5-year Treasury is yielding around 4.35%; for price declines to outweigh income over the next 12 months, interest rates would have to rise almost 1%.

Another way bond math can work in your favor is convexity, which reflects the rate at which the duration of a bond changes as interest rates change and is something most bonds possess. Let’s use the 30-year Treasury bond, which is yielding 4.5%, as an example. If interest rates rise half a percent to 5.0%, the bond’s total return would be -3% after one year. But if interest rates fall by an identical amount to 4.0%, it would be +13%. The difference is an example of convexity. While its potential benefits decline as a bond’s maturity shortens, it can still be an important advantage.

Perhaps the most important axiom is not mathematical, but colloquial: don’t let perfect be the enemy of good. The Fed may not be ready to cut rates until late in the year given stubborn inflation prints to start the year, but it likely won’t raise them again. And once inflation falls further, which we believe will be the case, so too should rates and bond yields. That should lead to price appreciation that complements coupon cutting. Exactly when that happens matters less than preparing for it by starting to extend the duration of a bond portfolio.

Tags Interest Rates . Fixed Income . Inflation . Markets/Economy .

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Duration is a measure of a security’s price sensitivity to changes in interest rates. Securities with longer durations are more sensitive to changes in interest rates than securities of shorter durations.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

Consumer Price Index (CPI): A measure of inflation at the retail level.

Bloomberg US Aggregate Bond Index: An unmanaged index composed of securities from the Bloomberg Government/Corporate Bond Index, Mortgage-Backed Securities Index and the Asset-Backed Securities Index. Total return comprises price appreciation/depreciation and income as a percentage of the original investment. Indices are rebalanced monthly by market capitalization. Indexes are unmanaged and investments cannot be made in an index.

Federated Investment Management Company