September Market Update: Short-Term Pain, Better Long-Term Potential

 

Why Bonds Fell So Sharply

Bond prices and interest rates move in opposite directions. When market interest rates rise, existing bonds generally decline in value because newly issued bonds are available at higher yields. The longer the maturity of a bond, generally the more sensitive its price is to changes in interest rates.

That relationship worked against bond investors in September. The 10-year Treasury yield rose more than half a percentage point during the month, ending September at 5.29%. The 30-year Treasury yield finished even higher at 5.68%. These were unusually large moves for the Treasury market and help explain the significant declines experienced by many bond investments.

Several fundamental factors contributed to the increase in yields. Inflation remains above the Federal Reserve’s 2% objective, economic growth has remained resilient, and higher energy prices have added to concerns that inflation could remain elevated. Investors have also become increasingly focused on heavy government borrowing and a growing supply of debt across financial markets, which can put upward pressure on the yields required to attract buyers.

The Federal Reserve added to the pressure when it increased its target interest rate by 0.25 percentage point in September, bringing the federal funds target range to 3.75%–4.00%. The Fed cited solid economic growth, resilient domestic spending, and still-elevated inflation in explaining its decision.

Technical market factors also appear to have amplified the selloff, particularly late in the month. As yields rose, some leveraged investors and other market participants were required to reduce risk or adjust their positions, adding to selling pressure. Hedging activity by some investors with exposure to mortgage-backed securities also contributed to Treasury selling as rising rates increased the interest-rate sensitivity of those portfolios. These trades can create a feedback loop in which rising yields trigger additional selling, which in turn pushes yields still higher.

These trading dynamics help explain the speed of September’s move, but they should not be viewed as the primary reason bonds declined. The underlying pressure initially came from concerns about inflation, interest rates, and government debt. Technical selling then appears to have intensified an already significant move.

The Other Side of Falling Bond Prices

It is easy to look at a negative monthly—or year-to-date—bond return and conclude that bonds have become less attractive. From a longer-term perspective, however, the opposite may be true.

A bond investor’s return comes from two primary sources: the income the bond pays and changes in its market price. Rising interest rates hurt the second component in the short run because existing bond prices decline. But they improve the first component because new bonds can be purchased at higher yields and maturing bonds can be reinvested at those higher rates.

That higher income accumulates over time and can help offset the initial decline in bond prices.

This is why the time horizon matters. An investor who needs to sell an intermediate- or long-term bond shortly after rates rise may experience a loss. An investor who continues holding a diversified bond portfolio, however, continues receiving interest and gradually benefits as the portfolio replaces older, lower-yielding securities with newer bonds offering higher yields.

Starting yields can also provide a useful indication of potential returns from high-quality bonds over longer holding periods. They tell us relatively little about what bonds will return over the next several months, when changes in interest rates can dominate performance. Over longer periods, however, the income generated by bonds becomes an increasingly important component of total return.

In other words, September’s decline in bond prices was painful, but it also improved the longer-term return potential of the asset class.

 

Higher Yields Change the Investment Landscape

The improvement in yields is particularly important when comparing today’s bond market with the low-rate environment investors experienced for much of the past decade.

When high-quality bonds yielded only 2% or 3%, investors received relatively little income for owning them. With many high-quality bonds now yielding around 5% or more, bonds provide a considerably more meaningful source of portfolio income.

Higher yields also affect the relative attractiveness of stocks. The S&P 500 ended September trading at approximately 19 times expected earnings. That translates to a forward earnings yield of a little over 5%, roughly comparable to the 5.29% yield available on a 10-year U.S. Treasury.

This does not mean stocks and Treasury bonds are interchangeable investments. Stocks offer the potential for earnings growth and long-term capital appreciation, while Treasury bonds provide much greater certainty around their promised payments. But the comparison illustrates how much the investment landscape has changed. When high-quality bonds offered very little income, investors had a greater incentive to accept the additional uncertainty of stocks in pursuit of higher returns. With bond yields now around 5%, investors have a more attractive alternative.

Higher bond yields therefore create a higher hurdle for stock valuations as well. If interest rates remain elevated, investors may be less willing to pay high prices relative to corporate earnings. At the same time, corporate earnings have remained strong, which continues to provide support for stock prices. Rather than providing a clear signal to favor one asset class over another, the changing relationship between stock valuations and bond yields reinforces the benefits of maintaining exposure to both.

A Difficult Month for Diversification

September also provided a reminder that diversification does not guarantee positive returns over short periods.

Stocks declined across U.S. and international markets, while rising interest rates simultaneously pushed bond prices lower. When stocks and bonds decline at the same time, diversified portfolios can experience periods when there are few places to hide. That can make diversification feel less effective precisely when investors would most like it to provide protection.

But diversification is not designed to ensure that something in a portfolio is always rising. Its purpose is to reduce dependence on any single investment, market, or economic outcome over time.

The year-to-date results help illustrate this point. Despite September’s declines, U.S. large-cap stocks have gained 12.30% this year, U.S. mid-cap stocks 9.88%, U.S. small-cap stocks 14.08%, developed international markets 14.64%, and emerging markets 10.61%. September therefore represented a setback within what has otherwise been a strong year for stocks.

Bonds have had a more difficult year, with U.S. core bonds down 2.85%, municipal bonds down 3.68%, and international bonds down 1.29% through September. While disappointing, those declines have occurred alongside the significant improvement in yields discussed above.

What to Watch

 

Interest rates will likely remain an important driver of markets in the months ahead.

The Federal Reserve will continue evaluating inflation, employment, and economic growth as it determines whether additional changes to short-term interest rates are necessary. Longer-term rates will also respond to factors outside the Fed’s direct control, including inflation expectations, economic growth, federal borrowing needs, and investor demand for Treasury securities.

Technical factors could also contribute to additional short-term volatility. If rates move sharply higher, leveraged investors and other market participants may need to further adjust their positions. Conversely, higher yields may eventually attract additional buyers and help stabilize the bond market.

Exactly where interest rates go next is difficult to predict, which is one reason we do not build portfolios around short-term forecasts.