In this article we are going to discuss our outlook on the 2023 bond market and the key dynamics in play.
How does the change in yields to maturity impact the expected returns of bonds in the next 12 months? The yield to maturity is the average annual yield of the bond until it becomes due.
Longer term bonds are more sensitive to interest rates
The shorter the average life of the bond, the closer the yield to maturity is to the actual annual interest paid on the bond. However, longer duration bonds are more influenced in the short term by the current level of interest rates. And sometimes price fluctuations can be extreme when interest rates are changed.
For example, if we invest $100,000 in a one-year Treasury bond now, at an interest rate of 5.25%, we will earn $5,250 in 12 months’ time, as the bond matures and is redeemed.
If we invest for a period of more than a year, then the return we earn is influenced more by the level of interest rates in the market. Remember as interest the rates rise, bond prices drop, and vice versa.
The table below dated Oct 13, 2023 (source Bloomberg) shows during the current period how much one can gain or lose in the next 12 months, given:
- The term of the Treasury bond selected.
- The rise or fall of short-term interest rates.
The longer the duration of the bonds, the greater the potential fluctuation of the coming 12 months.
|1.5% rate rise||3% rate rise||1.5% rate rise||0.5% rate rise||0.5% rate drop||1.5% rate drop||3% rate drop|
Currently, we see that the risk reward in the bond market is skewed towards the upside. In other words, for a given maturity and a given change in interest rates, one makes more when interest rates drop than when they rise.
So, for example, a rise of 150 basis points (1.5%) in interest rates would cause the 10-year Treasury to lose 5.8%, in the coming year, but if rates fell by a similar amount the same bond would earn 16.4%. For perspective, ten-year treasury yields have widened approximately 120 basis points so far this year. So, a 150 basis point move in the opposite direction is not an unreasonable possibility.
Bonds are now trading at some of the highest yield levels in 20 years. We believe this may be an attractive time to invest in the bond market, because:
- One earns high interest (coupons).
- We believe that the interest rate cycle may be near its peak – however we have less visibility as to whether rates are likely to remain at current levels, or drop in the near to medium term.
- If there is indeed a slowdown in the economy, then rates could drop, causing bond prices to rise.
- While we are not forecasting where interest rates will be in 12 months’ time, investors may who believe that rates will drop, may be able to reap a positive outcome on a risk-reward basis, especially in longer maturity bonds.
Getting help navigating the 2023 bond market
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