Bonds; Understanding the Effects of Maturity on Rate Changes
Bonds and notes represent corporate, government, and municipal debt. For example, the U.S. government issues Treasury bills, notes, and bonds; these securities are also referred to as T-bills, T-notes, and T-bonds. T-bills have an original issue maturity of 13, 26, or 52 weeks. T-notes mature in 1–10 years, and T-bonds have an original issue maturity of 10–30 years.
Fixed-income instruments are classified according to issuer, maturity, and quality. For purposes of this chapter, we will be covering the highest quality fixed-rate securities, U.S. government obligations.
Throughout the chapters, any reference to T-bills means a 1-month maturity. References to intermediate-term bonds refer to a Treasury with 5-year maturity. References to long-term bonds refer to a Treasury with 20-year maturity. Corporate, emerging markets, foreign, high-yield, and municipal bonds will be detailed in later chapters.
The table below shows total return figures for U.S. government securities with three different maturities along with inflation, as measured by the CPI. Total return includes the interest payments made by these securities plus any principal appreciation or minus any depreciation—bonds go up in value when interest rates fall and decrease in value when rates increase.
Phrased another way, there is an inverse relationship between a bond’s current value and interest rate changes. The greater a bond’s maturity, the more sensitive it is to rate changes.
U.S. Government Bond Performance by Decade [1970–2016]
U.S. Government | 1970s | 1980s | 1990s | 2000s | 2007–2016 |
Long term (20 years) | 5.5% | 12.6% | 8.8% | 7.7% | 6.7% |
Med term (5 years) | 7.0 | 11.9 | 7.2 | 6.2 | 5.4% |
T-bill (1 month) | 6.3 | 8.9 | 4.9 | 2.8 | 0.6% |
Inflation (CPI) | 7.4 | 5.1 | 2.9 | 2.5 | 2.0% |
These categories posted positive returns during all periods. This would not be the case for T-bills if inflation and income taxes were subtracted from their returns. The returns fixed-income securities enjoyed during the 1980s, 1990s, and through 2016 were largely due to falling interest rates.
The prime interest rate peaked briefly at 21.5% during the first half of 1981 and fell from there (3.75% in February 2017). Over the past 15 years (2002–2016), long-term government bonds experienced three negative years (2009 and 2013); in 2009 long-term bonds returned -14.9%, -11.4% for 2013, and -1.6% for 2015. For 2016, Treasurys with a 20+ year maturity posted a total return of 1.4% (-1.6% for 2015); 7-10 year Treasurys had a 2016 total return of 1.0% (1.6% for 2015).
Falling interest rates are a double-edged sword. A low rate environment means less current income for new investors. When rates are falling, principal appreciation can be moderate to high (e.g., in 2002, long-term government bonds had a total return of 17.8%—roughly two-thirds of this from principal appreciation alone).
During 2009, rate changes were minor, but capital depreciation for government bonds was massive (-18.3% long term and -4.4% for med-term). For the 2016 calendar year, the Barclays Aggregate Bond index (U.S. investment grade bonds) was up 6.4%. In 2013, Treasurys with a 20-year maturity depreciated 14.8% (partially offset by a 2.9% coupon rate). Long-term Treasurys had a 23.9% total return for 2014.