Bonds: Trading Coupons

Bond returns were up slightly, despite the fact that the Federal Reserve believes the economy is doing well. Our projected economic growth rate caused the Fed's members to decide there may be four, rather than three, interest rate increases this year. This occurred at the same time they increased their Fed Funds target rate by 0.25%, to the range of 1.75% to 2.00%. This overall positive performance points to the fact that most of the returns from bonds in the long-term come from the interest they earn, rather than moves in interest rates. With the U.S. benchmark 10-year bond near 3% for most of the quarter, the interest income of bonds in general exceeded the effects of expected rises in interest rates.

This quarter’s performance continues to enforce our view that the market has already priced in many of the anticipated interest rate increases as the economy continues to grow. On the negative side the yield curve, which is graphic illustration of rates compared to maturities, has become flatter. Whenever this curve flattens, some investors become concerned that the curve may invert (meaning that short-term rates are higher than long-term rates), which has sometimes been an indicator that the economy is in a recession (this is because more short-term investments and cash are necessary to keep companies operating when the economy slows down, similar to a household saving more in anticipation of less income due to a job loss, etc.).

Overall, however, this quarter did demonstrate the importance of holding bonds. As stock market volatility and losses in most markets other than the U.S. took place, bonds continued to be the mostly stable rock in a windstorm.