Bonds Are Back & How Do Rate Cuts Help the Economy?
Bonds Are Back
Since the Federal Reserve began raising interest rates, bond investors have seen their portfolio values drop. When interest rates rise, bond prices drop. The opposite is true when interest rates drop. The interest rate cycle has peaked. After some negative years for the U.S. Aggregate Bond Index (see chart below), the tide is turning. As of September 18th, the federal reserve cut interest rates 50bps signaling the rate hike cycle has concluded. What does this all mean for bond investors?
Let’s look at how investors make money in the Bond Market. First, when you purchase a bond, you are essentially lending money to an entity (such as a government or corporation) in exchange for periodic interest payments. These payments are typically made semi-annually and provide a steady stream of income. At the end of the bond’s term, you receive the original investment amount, known as the principal. This first method of returns from bonds is called interest income.
But there is another way to generate profits when buying bonds - capital gains. Bond prices fluctuate based on various factors, including changes in interest rates and the creditworthiness of the issuer. If you buy a bond at a lower price and sell it at a higher price before it matures, you can pocket the difference. This strategy works best when interest rates are declining or expected to decline. From July of 2020 until late 2023, investors in U.S. bonds were handed large amounts of capital losses (see chart below). But, as rate cut expectations crept into the market place this year, bond investors were finally rewarded with capital gains. When Bond Investors can collect interest income and capital gains, the asset class becomes very attractive for investors.
Lastly, we believe investing in bond funds or exchange-traded funds (ETFs) is a great way to add exposure to bond market in a diversified way. This helps spread risk and can provide more stable returns compared to investing in individual bonds. Additionally, bond funds offer liquidity, allowing you to buy and sell shares easily on the open market. By understanding these methods, you can effectively use bonds to enhance your investment portfolio and help achieve your financial goals. As always, discussing these products with your financial advisor will help understand how they fit into your portfolio.
How Do Interest Rate Cuts Boost the Economy?
Interest rate cuts are a powerful tool used by central banks, like the Federal Reserve, to stimulate economic activity. When interest rates are lowered, borrowing costs decrease for consumers and businesses. This makes loans for big-ticket items such as homes, cars, and business investments more affordable. As a result, consumers are more likely to spend, and businesses are more likely to invest in expansion projects. This increase in spending and investment can boost overall economic activity.
Lower interest rates also affect the financial markets. With reduced returns on savings accounts and other low-risk investments, investors often seek higher returns in the stock market or other investment opportunities. This influx of capital can drive up stock prices, creating a wealth effect where individuals feel richer and are more likely to spend. Additionally, businesses can benefit from higher stock prices as it becomes easier to raise capital through equity markets, further supporting economic growth.
Another significant impact of interest rate cuts is on the housing market. Lower mortgage rates make buying homes more affordable, which can lead to increased demand for housing. This not only benefits homebuyers but also stimulates related industries such as construction, real estate, and home improvement. Increased activity in these sectors can create jobs and further boost economic growth.
Finally, interest rate cuts can help manage inflation and stabilize the economy during downturns. By making borrowing cheaper, central banks can encourage spending and investment, counteracting the effects of a recession. This can help maintain price stability and prevent deflation, which can be harmful to the economy. However, it’s important to note that while interest rate cuts can stimulate economic activity, they must be used carefully to avoid overheating the economy and causing excessive inflation.
Importance of an Engaging an Advisor
Engaging a financial advisor, like Glacier Advisors of Raymond James, helps effectively manage your investments and achieving your financial goals. Our goal, through over 50 years of combined experience, is providing expert advice on investments, retirement planning, tax strategies, and more. Helping you make informed decisions tailored to your specific needs. We offer accountability and a structured plan, ensuring you stay on track to meet your objectives. By leveraging our expertise, we can work together to help reduce common financial mistakes, save time and gain access to a broader range of investment opportunities, ultimately enhancing your financial security and confidence.
- Brett Miller, CFA, CFP® - Financial Advisor
The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of Brett Miller and not necessarily those of Raymond James. Bond prices and yields are subject to change based upon market conditions and availability. If bonds are sold prior to maturity, you may receive more or less than your initial investment. There is an inverse relationship between interest rate movements and fixed income prices. Generally, when interest rates rise, fixed income prices fall and when interest rates fall, fixed income prices rise.
