Going forward, we’re shifting the focus of these quarterly videos to cover more investment topics that we hope will help you understand how we manage portfolios. This quarter we look at why we are currently using so many short-term bond funds in client portfolios—that is, bonds that mature anywhere from a few months to a couple years, versus longer-term bonds that mature in 10 or 20 years.
We started shifting to primarily using short-term bonds in 2021 when it became apparent that the Federal Reserve would need to step in and raise interest rates to combat inflation. The Fed aggressively raised interest rates in 2022 and 2023, to the degree that two-year Treasury bonds (and by extension, most short-term bonds) began paying rates that equaled or exceeded similar bonds with much longer maturities. That situation really didn’t reverse until late 2024, and the difference in yields remained much less than it was three years ago. This narrow gap allows us to give clients most of the return of long-term bonds, without most of the accompanying risk.
You may be wondering why the yields on longer-term bonds have not moved up to the same degree as short-term bonds. While short-term bonds are strongly affected by the Federal Reserve, yields on longer-term bonds are mostly determined by the bond market itself. At its core, the bond market merely reflects where bond investors expect long-term interest rates to be in the future.
Whether logical or not, most bond investors have only experienced long-term bond rates of 6% or less over the last 20-plus years. They may have been assuming that the Fed would quickly cut short-term interest rates, thereby making current long-term rates attractive again. But there’s also the likelihood that they’ve underappreciated just how stubborn our current bout of inflation would be. So, while the Fed did cut short-term interest rates to a degree in late 2024, it appears that the Fed’s battle with inflation is not over.
Inflation as measured by the Consumer Price Index has risen now four-straight months, reaching 3% on annual basis in January. The economy has also held up very well as evidenced by the January jobs report that showed that the unemployment rate is now back down to 4%. Stubborn inflation, together with a strong economy, has made the Fed’s decision in January, to leave interest rates unchanged, an easy one.
Until the gap between short-term and long-term bond rates shifts significantly, we’ll continue to allocate predominantly to shorter-term bonds. We hope you now have a better appreciation of our approach to bond investing in early 2025.
As always, if you have any questions about what was covered in this video, reach out to your Boulay Financial Advisor. To learn more about Boulay, please check out our website or email us at learnmore@boulaygroup.com.
This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. Any tax advice contained herein is of a general nature. You should seek specific advice from your tax professional before pursuing any idea contemplated herein. This is meant to be a reference/guide, individual circumstances can influence outcome, verify planning with accounting and financial professionals.
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Indices are unmanaged and do not incur fees, one cannot directly invest in an index. Past performance does not guarantee future results. These opinions are based on our own observations and third-party research and are not intended to predict or depict performance of any investment. These views are as of the open of business on March 1, 2025, and are subject to change based on subsequent developments. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. These views should not be construed as a recommendation to buy or sell any securities. Diversification cannot guarantee a profit or protect against a loss. All investing involves risk, including the possible loss of principal. Indices are unmanaged and do not incur fees, one cannot directly invest in an index.