How And When The Bond Crash Can Make Your Retirement Better

Retirement

Long-term savers can be thankful that interest rates are higher. They’re finally getting a real return.

I

f you have a chunk of retirement money in bonds, you’re probably feeling miserable. This year’s spike in interest rates has wrecked what was supposed to be the safe part of a balanced portfolio.

Cheer up. The bond crash in fact probably leaves you better off.

This paradoxical result has to do with the fact that rising rates do more than depress bond prices. They also mean higher future returns from bonds.

It all depends on how long you can hang on before spending that bond money. If the time to spend is at least seven years away, and if you have an average bond portfolio, then the crash improves your future lifestyle. The good from higher bond coupons down the road more than compensates for today’s damage to bond prices.

The important number for a fixed-income investor is the real interest rate. That’s the stated coupon interest minus expected inflation. It represents how fast the bondholder’s spending power is growing.

This year, real rates have zoomed upward. A rate rise makes bonds bought last year worth less today. But, following this unpleasantness, prospects are better. From here on, you can expect a higher reward for owning a bond.

We have been living in strange times. Responding to the financial crisis of 2008-2009, the government decided it would be a good idea to print money and hand it out. The easy money depressed interest rates.

It was fun for borrowers—home buyers, for example, or Wall Street buyout artists. But for every one of these winners there was a loser. A retirement saver, for example.

At the start of this year the real interest rate on ten-year Treasury bonds was -1%. So a conservative saver was locking in, as the reward for saving, a loss of purchasing power.

And then the Federal Reserve belatedly realized that printing money wasn’t such a great idea. It could cause prices to go up.

Following the Fed’s crackdown in the money markets, the real yield on Treasuries due in 2032 has climbed to 0.9%. Savings set aside for later enjoyment are now gaining in purchasing power instead of losing purchasing power.

That’s the way the world should work, but after years of loose money the swing in interest rates comes as a quite a shock. The rate shock is taking the air out of bitcoin, unicorn valuations and the wishful-thinking enterprises in the Ark Innovation fund.

The good and the bad for bondholders is displayed in two graphs showing the long-term effects of a permanent boost in interest rates of the sort we have had this year. The first plots the numbers for an investment in the Vanguard Total Bond Market fund, a diversified collection of high-quality bonds with a heavy contribution from Treasury debt.

From where they are now, interest rates could, of course, go back down or proceed further upward. The graph assumes, neutrally, that rates stay put. It also assumes that future inflation averages the amount implied by current bond market prices. That assumption could, again, turn out to be too optimistic or too pessimistic.

The percentage change displayed in the charts is the expected impact, in future purchasing power, of this year’s bond market correction. The impact depends on how long you stay put. If you have money in Total Bond Market that you were planning to spend right away, the crash makes you 12% worse off. If it’s money you’re going to be spending in 15 years, you are now 16% better off.

Without the rate rise, someone who had $100 in that bond fund could look forward to having only $90 of purchasing power in 2037. That’s what negative TIPS yields do.

With the rate rise, the $100 has quickly shrunk to $88 but is on target to grow to $105 of purchasing power in 2037.

What if rates go back down to where they were? That would not be good for long-termers. It would make it less likely that money a 60-year-old couple puts away today will cover a cruise they want to take at age 75. But there wouldn’t be a lot of complaining. Brokerage statements would display a magnificent rebound.

The second graph looks at the effect of this year’s rate move on a collection of long-term Treasury bonds. The immediate damage there is greater and the recovery time more than twice as long.

These graphs consider only what happens to money now in the bank. They understate the good that a bond crash does to a 401(k) still receiving new contributions. Younger workers should be thrilled that bonds got a shellacking.

A crucial element of this story is that this year’s bond crash has come almost entirely via an increase is real rates. Count your blessings. Had the rate rise consisted primarily of an increase in long-term inflation expectations, there would be no happy ending.

The market could be wrong in expecting that the Fed will tame inflation. If the Fed fails, all savers are in peril.

Note: Calculations use yields reported on June 14. (Track the yields on Treasury Inflation-Protected Securities here.) Expected inflation is measured by the spread between nominal and real yields (the so-called breakeven rate), minus a 0.1 percentage point allowance for a risk premium in nominal bonds.

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