How Rate Changes Affect Bonds Differently

From the Baltimore Clubhouse – If you’ve ever thrown a stone into a pool of standing water, you’ve likely made at least two observations.

First, weight matters. The heavier the stone, the bigger the ripples.

Second, ripples nearest to where the stone hits the water are strongest, and they grow weaker as they expand outward.

This analogy is all you really need to understand how the Federal Reserve’s rate policy generally works.

Think of the economy as a pool of water. And the federal funds rate – the base rate at which banks may lend to each other overnight – is the stone.

The Fed’s mandate is to smooth the business cycle by mitigating extreme contractions or expansions. Its main policy lever is the federal funds rate, which it can raise or lower.

Such changes cause ripple effects in the economy that start with interest rates and radiate toward inflation, unemployment and GDP growth.

The Fed can’t be too heavy-handed or it may cause unintended splash-back. So it generally prefers to use many light stones (small, incremental rate changes) rather than a few heavy ones.

While the biggest impact from changing the federal funds rate is on other interest rates, its indirect effects on the rest of the economy tend to be more muted and unclear.

This makes it very difficult for the Fed to know precisely how its rate policy is affecting the economy.

Casting Stones

When the Fed raises rates, the cost of borrowing rises, which may impede business growth, decrease consumer spending and contribute to slower economic growth.

For investors, a higher-rate environment also makes fixed-income assets (bonds) more appealing, and may also curb demand for equities.

But when the Fed lowers rates, as it recently did for the first time in more than 10 years, something different is supposed to happen.

Lower rates imply cheaper borrowing, greater consumer spending, less demand for fixed-income assets and the overall stimulation of economic growth.

Or at least that’s the theory.

In reality, there’s no guarantee that Fed policy will work the way it’s supposed to on the economy at large. But we can watch its immediate effect on one market in particular…

Short-Term and Long-Term Bonds React Differently

Since the federal funds rate is a very short-term interest rate, changes to it have the biggest and most direct effect on short-term bonds.

Short-term Treasury yields have a nearly direct relationship to the federal funds rate, as you can see in the below chart.

But if we look at the relationship between the federal funds rate and longer-term Treasurys, we see a weaker and more muted impact on their yields.

Take the two-year and 10-year Treasury bonds.

As you can see, the 10-year Treasury yield is almost completely independent from the federal funds rate. But the two-year Treasury yield moves in near tandem to the federal funds rate.

Those are government-issued bonds. How about the corporate bond market?

As it turns out, the effect of rate changes is even less direct. While rate changes affect coupon rates for newly issued bonds, the relationship between the federal funds rate and corporate bonds depend heavily on the yield.

For example, high-yield bonds – riskier bonds that carry a rating below BBB – show much less of a correlation to rate changes. In fact, for most of the seven years of the Fed’s zero-rate policy, the high-yield market was offering greater yields than after the Fed began raising rates in 2015.

As I’ve written about previously, high-yield bonds – sometimes called “junk bonds” – include a wide spectrum of risk that is far less speculative than some may think.

Not all bond yields perfectly follow the path of Fed rate policy. So if you’re looking for a good yield in what could become a falling rate environment, long-term bonds and high-yield bonds may become your saving grace.

Good investing,

Anthony