Fed’s Rate-Cut Plan and Bond Investments in the US Election Year

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Interest rates are a key aspect of bond investments. The interest rates announced by the Fed will affect the attractiveness of existing bond yields. If the Fed lowers rates, existing long-term bond yields become more attractive compared to new issues and vice versa.

This year, speculations as well as official statements point to the Fed’s plan to cut interest rates. However, the Fed’s policy makers resist moving forward with the rate-cut plan until the central bank has ‘greater confidence’ that inflation is slowing sustainably to its 2% target.

Despite the rate-cut delays prompted by The Fed, Chairman Jerome Powell announced that the central bank is unlikely to raise interest rates. In other words, even if the rate-cut plan is revoked, the interest rates are likely to remain steady for the foreseeable future.

This bodes well for bonds, especially with the election just around the corner. 

Regardless of the uncertainty the Fed faces in dealing with inflation, bonds have performed positively in election years. Perceived as more stable, bonds are a more attractive option compared to highly volatile stock markets during these times.

Looking At Bond Performances In Election Years

Bonds, perceived as a safer investment, provide more stable returns than stocks in election years. The volatility is lower than stocks, which are susceptible to fluctuations based on anticipated policies of the incoming administration, especially those that could impact certain sectors.

Source: Morningstar

The chart above compares the performance of stocks and bonds during election years. Panel A reveals that stocks delivered an average return of 10% from 1976 to 2020. In contrast, Panel B shows that bonds generated a slightly lower average return of 7% during the same period.

While stocks generate higher average returns, they also exhibit greater volatility. The chart showcases negative returns of -9% in 2000 and a drastic drop of 37% during the 2008 financial crisis. Conversely, bonds exhibit a more consistent performance throughout election years even though their returns are lower.

The Opportunity Presented by The Fed’s Rate-Cut Plan

Image source: Freepik

Given the historically lower volatility of bonds in election years, the Fed’s potential rate cuts present an even more attractive opportunity for bond investors. However, the central bank is currently holding off on implementing rate cuts until inflation nears its 2% target.

If the Fed does decide to cut rates, existing long-term bonds would likely benefit. Here is why:

  • Increased bond prices: When new bonds are issued with lower yields due to a rate cut, the existing bonds with higher fixed interest rates become more attractive to investors, surging their prices as well.
  • Potential for higher returns: With higher fixed interest rates than newly issued bonds, investing in long-term bonds can potentially give you higher total returns.
  • Reduced risk of price fluctuations: Lower interest rates could bring higher stability to existing bonds, reducing the risk of price fluctuations.

The potential benefits of rate cuts for existing bonds make them an even more compelling option for investors seeking stability during uncertain times of an election year. This, in turn, makes investing in them potentially more valuable than low-risk instruments like saving accounts or certificates of deposits (CDs).

Saving accounts and CDs typically adjust their rates in line with the current interest rates. Thus, the potential of rate cuts brings advantages of fixed, higher interest rates for existing bonds. This can provide a hedge against inflation and potentially higher returns, all while the risk of volatility remains low.

What are Bonds?

We have been discussing bonds and how they could benefit from potential rate cuts by the central bank this year so far. But what exactly are bonds?

Before we continue, here are some key terms you will want to be familiar with:

  • Issuer: It refers to any institution issuing bonds to gather funds from investors.
  • Face value: It is the amount of investment principal paid by investors on the day of bond issuance.
  • Coupon rate: It is the fixed interest rate paid to investors throughout the bond’s life until maturity.
  • Maturity date: It is the day when a bond reaches its end and the issuer must repay the face value to the investor.
  • Yield: It refers to the total return investors expect to receive on their bond investment.
  • Market price: It refers to the price at which bonds are currently being traded between investors in the secondary market

Bonds are essentially debt securities issued by the government, municipalities, and corporations. Bonds are issued as a means to gather funds from investors to finance various projects and operations.

These funds are then returned to investors when the bonds mature. Aside from getting their face value investment back from issuers, investors will also earn returns from coupon rates throughout the bond’s life.

What makes bonds a potentially attractive investment is that their yields are fixed from the day they are issued. You know exactly how much interest you will earn throughout the life of the bond, regardless of interest rate fluctuations.

The fixed rates offered by bonds are beneficial in the case of rate cuts. This scenario will drive up the demand for existing bonds due to the potential for higher returns, explaining why their market prices will also surge.

Inverse Relationship Between Interest Rates and Bonds

The main reason why lower interest rates drive up bond market prices is because of the inverse relationship between the two.

How does this work?

Say you bought a bond a while back with a fixed interest rate of 5.75%. If the Fed’s rate-cut plan is positive (assume it drops to 5%), your existing bond becomes even more valuable.

The reason behind this is that your existing bonds have higher yields than the newly issued ones, which should follow suit with rate cuts. With their locked-in, higher rate, they become even more attractive to investors seeking higher returns.

Strategies for Investing in Bonds During an Election Year

Election years can introduce volatility to the markets, particularly to instruments sensitive to policies implemented by the incoming administration. This is where bonds can be a good way to add stability or diversify your portfolio, preventing you from major losses.

However, not all bonds are created equal. There are strategies that you should implement to maximise your potential returns while still managing risks that may follow. These include:

Choose your bond(s) wisely

Bonds are mainly classified into three categories, government, municipal, and corporate bonds. Each of them has its own set of benefits and risk profiles you should be aware of.

  • Government bonds: Government bonds are considered to be the safest option. They’re backed by the government’s promise to repay on the maturity date. Though they typically offer lower returns.
  • Municipal bonds: Municipal bonds are issued by local governments to fund municipality projects like building schools, roads, and bridges. They offer tax-exempt returns for investors, but their liquidity may be lower than government bonds.
  • Corporate bonds: Corporate bonds are issued by companies like Microsoft and Apple as well as banks such as BNP Paribas and Lloyds Banking Group. They offer higher yields than government bonds but with a higher risk that may follow.

Diversify with Bond ETF

Though deemed as a more stable instrument, diversification is still key in bond investment to manage risks that may follow. That’s where Bond ETFs come in handy, acting like baskets of bonds from different issuers.

By investing in Bond ETFs, you automatically spread your risk across a diverse range of the bond market. It also offers effectiveness, as you will not need to pick individual bonds – perfect if you are a beginner who wants to keep things simple.

Key Takeaways

The Fed’s rate-cut plan is highly anticipated in this election year. If the central bank proceeds with the rate cuts, bond investment can potentially be an attractive instrument, amidst the uncertain and significantly volatile stock markets.
Ready to explore the potential of bond investing? UTrade is here to help you navigate the bond market with confidence. It is equipped with a user-friendly interface, a diverse selection of bonds, and valuable resources to empower you to make informed investment decisions.

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