A Lawyer’s Guide to Bonds and Interest Rates
What in the world is going on with bonds? That is one of the most common questions I hear these days. Interest rates have gone up considerably in a very short period of time. When that happens, bond prices go down considerably so halfway through 2022, the bond market is off to its worst start in history. So how does a lawyer make sense of what we’ve seen with respect to inflation, interest rates and bond returns?
Effects of Rising Rates
First, think about what direct impact rising interest rates have on your personal financial situation. It’s common for lawyers, especially earlier in their careers, to have an ongoing line of credit with their bank. Lawyers tap these lines of credit to pay regular expenses and their quarterly estimated tax payments. The reason many lawyers use these lines of credit is due to a timing mismatch between when their tax payments are due and when they receive distributions from the firm. One thing to keep an eye on with this rising interest rate environment is your borrowing cost for the line of credit. Most times, they involve floating interest rates tied to the Fed Funds or Prime Rate. If Fed Funds and the Prime Rate go up (which they have and will very likely continue to do so), then your cost of funds will go up. I suggest you talk with your personal banker to ensure you get the best rate possible. If your bank is also banking your firm, you may have a good chance of negotiating a better rate on your line of credit to ensure you keep your borrowing costs at a reasonable level.
The Silver Lining
Next, it’s important to understand the silver lining of rising rates as it relates to your bond portfolio. No one likes to see a negative number next to their bond returns. We are accustomed to bonds being the anchor in our portfolio and the steadying force when stocks misbehave. However, so far in 2022, bonds have at times been down even more than stocks. As of this writing, the Aggregate Bond Index is down somewhere between 8-9% for the year. That is highly unusual and signifies how difficult 2022 has been for bonds. The reason bonds are negative for the year is quite simply rising interest rates. Inflation is clearly a big problem, so the Fed must raise rates to try and tame the inflation monster. In doing so, bond prices have dropped significantly. However, the silver lining is that bond yields have also gone up. Bonds are now paying attractive interest, which over the long run, is the most important component of a bond’s return.
So, while it’s painful to see your bonds in negative territory, keep in mind that your bonds are also going to start paying you a much better interest rate and that better interest over time will more than make up for the negative price impact of rising rates. So, like most investing, the thing to keep in mind is… keep a long-term perspective. In the medium-to-long run, it’s a good thing that rates have gone up because your bonds are now going to pay you an attractive yield, and that’s what matters most.
It has been a crazy first six months in 2022. Hopefully, this article will help you keep things in perspective and continue to make good decisions even during these uncertain times.
Justin works closely with clients to design wealth management plans that take into account the full spectrum of their career and personal concerns with a specialization in advising law firm partners. Justin earned his MBA from Northwestern University’s J.L. Kellogg School of Business.