With the rise in short-term interest rates, it has been a difficult first half of the year in the bond market. Bond prices have adjusted lower based on the increase in market interest rates and expectations for future increases. Because bond coupons are quite low following a period of extremely low market rates, interest rate increases are reflected in bond prices more than in prior cycles. While we generally own shorter maturity bonds, even these bonds have fallen in price since the beginning of the year.
Despite the challenging environment, there are some positives created by the shift in market conditions. First, higher interest rates translate to higher income on newly issued bonds and bond funds. This means bonds can do more of what they are supposed to do in a portfolio – provide a steady income stream with lower price volatility than stocks. Second, because the shape of the yield curve is very flat, short maturity bonds pay interest rates that are very close to those of longer maturity bonds. The smaller difference between short-term and long-term rates enables investors to build a portfolio with lower price volatility and higher potential for reinvestment opportunities.
Finally, credit conditions are very strong. Corporations are much better prepared for the challenging economic environment, having built high cash positions and having refinanced legacy higher cost debt. Although there are pockets of risk in sectors of the high yield bond market, we are comfortable with the credit quality of the bonds across our portfolios. Even if the economy worsens, we do not expect it to cause significant further bond price deterioration.
