Navigating the Resilient Bond Market: Unlocking the Power of Higher Coupons

As investment-grade bond investors grapple with the aftermath of 2022's double-digit losses and ongoing volatility, a glimmer of hope emerges. Even if the Federal Reserve pauses its interest-rate lowering cycle, the bond market is becoming more resilient, thanks to the simple bond math of fixed-rate debt.

Unlocking the Resilience of Higher Coupons

The Coupon Advantage: Older Bonds vs. New Issuances

The implications of this bond math are not widely recognized. When the market's required yield to maturity changes for a particular term, such as 10 years, buyers and sellers collectively reprice fixed-rate debt at that term to match the new yield. However, because the coupons do not change, a difference emerges between 10-year bonds that originated as 15-year bonds in a lower interest-rate environment, like 2019, and new 10-year bonds issued in a higher-rate world, like 2024. Even if their respective yields to maturity match in the present, the older debt still pays a lower coupon, while the newer debt pays a higher coupon. This means that if yields subsequently spike, the higher coupon bond will lose a bit less because it pays more of its yield to maturity upfront.

Comparing Bond Resilience: Bond A vs. Bond B

Consider two fixed-rate, semiannual-pay bonds with 10 years until they mature. Bond A is priced at a yield to maturity of 5.5% and began its life five years ago as a 15-year bond with a 4.0% coupon; it is thus priced at $88.58. Bond B is a 10-year 5.5% coupon new issue priced at $100, or par. If the required yield for 10-year debt shot up 100 basis points, bond A would be expected to lose 7.62%, while bond B would drop 7.27%, a difference of 35 basis points. This illustrates the resilience of higher-coupon bonds in the face of rising yields.

The Broader Market Implications: Increased Coupon Levels

Turning to the broader investment-grade bond market represented by the Morningstar US Core Bond Index, its par-weighted coupon, a point-in-time average of new-issue yields, has risen significantly. In March 2022, it fell to a 20-plus-year low of 2.395%; through August 2024, it had climbed to 3.321%, a more than one-third increase. With Treasury yields across maturities now in the 3.5%-4.9% range, the bond market's par-weighted coupon will continue to inch higher with each new issue, even if rates remain unchanged or fall slightly.

Increased Resilience: Offsetting Longer Maturities

As the investment-grade bond market's par-weighted coupon moves higher, it will prove more resilient than in 2022 to another surge in yields. While greater issuance of longer-term bonds could offset the impact of higher coupons, as longer-maturity bonds are more sensitive to interest-rate changes, this hasn't happened. In fact, the investment-grade bond market's weighted average maturity fell to about 8.2 years from 8.8 years between March 2022 and late September 2024.

Alternative Strategies for Inflation-Wary Investors

Investors worried about another inflation-induced selloff and expecting the federal-funds rate to remain elevated relative to historical norms have other options. One is to hold ultrashort bond or money market funds, which can provide a buffer against rising rates. Another is leveraged bank-loan strategies, which pay a large spread above and adjust up or down with short-term rates. While such investments come with heightened credit risk, a good active strategy can help manage that risk better than most. However, these strategies will likely lag if rates fall, and higher-coupon bonds will also underperform their lower-coupon counterparts in a falling rate environment.

The Resilient Bond Market: A Beacon of Hope

For investors using their fixed-income portfolio allocation for ballast, the knowledge that the investment-grade bond market is more resilient, thanks to higher coupons, will be good news. As the bond market's par-weighted coupon continues to rise, it will provide a cushion against future yield surges, offering a glimmer of hope in an otherwise volatile fixed-income landscape.