A More Resilient Bond Market

Investment-grade bond investors still reeling from the pain of 2022′s double-digit loss and subsequent volatility may be able to take heart even if the Federal Reserve pauses the interest-rate lowering cycle it started on Sept. 18, 2024. Each day that yields remain at current levels, which are still much higher than a few years ago, the market is becoming more resilient. That’s less a prediction than the simple bond math of fixed-rate debt.

The implications of that math aren’t that widely recognized. Ignoring credit considerations, such as default potential, whenever the market’s required yield to maturity changes for a particular term, such as 10 years, buyers and sellers collectively reprice fixed-rate debt at that term to match the new yield. Yet, because their coupons do not change, a difference then emerges between 10-year bonds that originated as 15-year bonds in a lower interest-rate environment, like 2019, and new 10-year bonds issued in a higher-rate world, like 2024. Even if their respective yields to maturity match in the present, the older debt, in this case, still pays a lower coupon and the newer debt a higher coupon. If yields subsequently spike, however, the higher coupon bond will lose a bit less because it pays more of its yield to maturity upfront.

Consider two fixed-rate, semiannual-pay bonds with 10 years until they mature. Bond A is priced at a yield to maturity of 5.5% and began its life five years ago as a 15-year bond with a 4.0% coupon; it is thus priced at $88.58. Bond B is a 10-year 5.5% coupon new issue priced at $100, or par. If the required yield for 10-year debt shot up 100 basis points, bond A would be expected to lose 7.62%, while bond B would drop 7.27%, a difference of 35 basis points.

Turning from a simple comparison to the broad investment-grade bond market represented by the Morningstar US Core Bond Index, its par-weighted coupon, a point-in-time average of new-issue yields, has risen significantly. In March 2022, it fell to a 20-plus-year low of 2.395%; through August 2024 it had climbed to 3.321%, a more than one-third increase. And with Treasury yields across maturities now in the 3.5%-4.9% range, the bond market’s par-weighted coupon will inch higher with each new issue if rates remain unchanged or even if they fall some.

As its par-weighted coupon moves higher, the investment-grade bond market will prove more resilient than in 2022 to another surge in yields. Granted, greater issuance of longer-term bonds could offset the impact of higher coupons because longer-maturity bonds are more sensitive to interest-rate changes. But that hasn’t happened. The investment-grade bond market’s weighted average maturity fell to about 8.2 years from 8.8 years between March 2022 and late September 2024.

Investors worried about another inflation-induced selloff, and who expect the federal-funds rate will remain elevated relative to historical norms, have other options. One is to hold ultrashort bond or money market funds. Another is leveraged bank-loan strategies, which pay a large spread above, and adjust up or down with, short-term rates. The Morningstar LSTA US Leveraged Loan 100 Index, for example, only fell 0.68% in 2022 and has otherwise posted solid to strong gains in recent years. To be sure, such investments come with heightened credit risk, but a good active strategy like Fidelity Floating Rate High Income FFRHX or T. Rowe Price Floating Rate PRFRX can keep that risk in check better than most. Such strategies, though, will likely lag if rates fall. And, for that matter, higher-coupon bonds will also underperform their lower-coupon counterparts in a falling rate environment. Still, for investors using their fixed-income portfolio allocation for ballast, the knowledge that the investment-grade bond market is more resilient, thanks to higher coupons, will be good news.