In the August What’s Trending, we discussed the changing shape of the yield curve and why longer-term interest rates have remained elevated even as the Federal Reserve has begun moving short-term rates lower. Since then, the bond market has continued to experience volatility as inflation concerns, energy prices, federal borrowing needs, and questions surrounding the country's growing debt burden have influenced interest rates.

For those who own bonds or fixed-income funds, this environment can understandably be frustrating. However, we believe it is important to look beyond the recent movement in bond prices and understand what higher interest rates may mean going forward.

Understanding the Relationship Between Rates and Bond Prices

One of the more confusing aspects of fixed income is the relationship between interest rates and bond prices.

Simply put, when interest rates rise, the value of existing bonds generally falls.

If a newly issued bond offers a higher yield, an older bond paying a lower rate becomes less attractive unless its price adjusts downward. This is one of the primary reasons many bond investments have experienced price pressure as Treasury yields have moved higher.

But price is only one part of a bond's return.

The other important component is the income the bond generates. While higher interest rates can initially reduce the market value of existing bonds, they also allow maturing bonds and new investments to be reinvested at higher yields.

Over time, that additional income can help offset some, or potentially all, of the earlier decline in price.

In other words, the same increase in interest rates that can create an unrealized loss today can also improve the income and potential return available going forward.

Why Higher Yields Matter for Bond ETFs‍

This becomes especially important when looking at bond ETFs. Unlike an individual bond, which typically has a specific maturity date when the principal is returned, a bond ETF owns a diversified portfolio of individual bonds with different maturities.

As bonds inside the ETF mature, the proceeds are continually reinvested.

When market yields are higher, that reinvestment can occur at more attractive rates, gradually increasing the income generated by the portfolio.

We are already seeing why this matters. The Treasury yield curve continues to offer yields that would have been difficult to find in high-quality fixed income for much of the period following the Financial Crisis.

At the same time, the curve has become considerably steeper, with longer-term yields remaining well above shorter-term rates. While that environment has created price volatility, it has also expanded the number of opportunities available to those seeking income.

A Different Environment for Fixed Income

That is an important change from the extremely low interest-rate environment of the past. For many years, generating meaningful income from bonds often required accepting more credit risk or looking elsewhere in the market.

Today, Treasuries and other high-quality fixed-income investments can provide considerably more income than they did when rates were near historic lows.

There may also be another potential benefit if economic conditions change. If inflation continues to moderate, energy prices pull back, economic growth slows, or markets begin expecting lower interest rates, Treasury yields could eventually decline.

Because bond prices generally move in the opposite direction of interest rates, a decline in yields could provide price appreciation in addition to the income being generated.

That outcome is not guaranteed, but it illustrates why today's starting yields may provide a more attractive foundation for fixed income than we have seen for much of the past decade

The Highest Yield Is Not Always the Answer

This does not mean that we believe everyone should simply buy the longest maturity bond available.

Duration, credit quality, liquidity, income needs, and the role an investment plays within the overall portfolio still matter.

Longer-duration bonds can experience considerably greater price movements when interest rates change. That is why we believe fixed income should be evaluated as part of the entire portfolio rather than based solely on which bond currently offers the highest yield.

The Role of Fixed Income in a Diversified Portfolio

We also believe it is important to remember why fixed income is included in a diversified portfolio in the first place.

The purpose is not simply to own bonds because a portfolio is supposed to contain a certain percentage of stocks and bonds.

Fixed income can generate income, help reduce overall portfolio volatility, provide liquidity, and create diversification from equities.

During periods of market stress, it may also provide a potential source of funds that can be used for distributions or to take advantage of opportunities elsewhere in the portfolio.

Diversification also means that every portion of a portfolio will not perform well at the same time. There will be periods when equities significantly outperform bonds and periods when the income and stability provided by fixed income become considerably more valuable.

If every investment responded to economic conditions in the same way, there would be little benefit to diversification.

Looking Beyond the Gain-or-Loss Column

For us, the current fixed-income environment is a good example of why it is important to look beyond the number shown in the gain-or-loss column.

Recent increases in interest rates have created challenges for bond prices, but they have also increased the income available from high-quality fixed income.

They may also be creating opportunities that were largely unavailable when rates were much lower.

As we have stated previously, our focus is not on predicting every movement in interest rates or reacting to short-term changes in bond prices.

We believe our responsibility is to understand how the environment is changing and determine how those changes affect the role each investment plays within the broader financial plan.

Fixed income will continue to experience periods of volatility, as other areas of the market do, but today's higher yields have created opportunities we believe are worth understanding.

As always, we aim to make thoughtful decisions based on your needs, risk tolerance, and long-term objectives, while staying focused on what matters most: providing you and your family with Financial Peace of Mind.

We hope that you are enjoying the cooler temperatures and look forward to seeing you soon!