Federated Hermes Premier Municipal Income Fund : Stubborn inflation doesn't change the bond math

Yesterday's hotter-than-expected inflation report might prolong this period of elevated interest rates, but should it postpone the duration extension trade for fixed-income investors?

The annualized Consumer Price Index (CPI) rose 3.5% in March compared to 3.2% in February and versus forecasts for 3.4%. The futures market now expect as few as two quarter-point reductions this year-less than the Federal Reserve's recent projection of three. Investors considering moving assets to bonds might conclude they should put those plans on hold. After all, money market and stable value yields remain north of the Bloomberg Aggregate Bond Index. But while timing the movement in interest rates isn't any easier than timing the stock market, fixed-income investors have bond math on their side. Let me explain.

Duration is related to the maturity of a bond. The longer it takes to get your principal back, the more sensitive the bond's price is to changes in interest rates. Bonds with longer maturities will go up in price more than bonds with shorter maturities if rates fall. That's why many investors wonder if it's time to extend duration to benefit from a potential decline in interest rates.

Of course, extending duration too early can lead to price depreciation. But with interest rates significantly higher today than they have been for much of the past 15 years, this risk is much more muted than when the federal funds level was lower. For example, in March of 2021, when 5-year Treasury rates were at 0.4%, it only took a tiny increase in rates, from 0.40% to 0.48%, to wipe out an entire year's worth of income from coupon payments. Today the 5-year Treasury is yielding around 4.6%; for price declines to outweigh income over the next 12 months, interest rates would have to rise almost 1%.

Another way bond math can work in your favor is convexity, which reflects the rate at which the duration of a bond changes as interest rates change and is something most bonds possess. Let's use the 30-year Treasury bond, which is also yielding around 4.6%, as an example. If interest rates rise half a percent to 5.1%, the bond's price would decline 3% after one year. But if interest rates fall by an identical amount to 4.1%, the price would rise to 13%. That 10% difference is an example of convexity. While its potential benefits decline as a bond's maturity shortens, it can still be an important advantage.

Perhaps the most important axiom is not mathematical, but the caution to not let perfect be the enemy of good. The has made clear they are done raising rates. They may not be ready to cut rates given stubborn inflation prints to start the year, but once it cools, the fed funds target range could fall and bond prices rise. Exactly when that happens matters less than preparing for it by starting to extend the duration of a bond portfolio.