Should Retirement Savers Own Bonds?
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On November 2nd, the Fed approved another 75 basis point rate hike. But since then, the yield on 10-year U.S. Treasury bonds has dropped from just over 4.1% down to 3.8%. In other words, while interest rates set by the Fed have increased, bond yields have decreased.

Bonds have been the story of the year. In fact, intermediate term U.S. Treasury bonds are on track for their worst year in history, down close to 11% year to date. If the year ended today, this would only be the sixth time in over 50 years that intermediate term treasuries have had a negative calendar year return. And historically, those negative returns have only been around 1% or less.

Given their current year performance, especially when compared to history, it's no surprise that investors are concerned about the bonds in their portfolio.

Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte. And to help address those concerns, I'm covering three things today. Number one, why bond yields are not moving in lockstep with interest rates set by the Fed. Number two, how long it takes for bond losses to recover. And number three, why retirement savers should maintain exposure to bonds for the long run. For the links and resources mentioned today, just head over to youstaywealthy.com forward slash 173.

The bond market is wildly complex, and the reason for owning bonds is different for every investor. For some, bonds are speculative. They're bought and sold throughout the day in an attempt to outsmart the markets. For others, bonds are used to improve their risk-adjusted returns during the accumulation phase of life. In other words, adding some bonds to a diversified portfolio of stocks can actually help to reduce risk and also improve long-term returns.

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And during catastrophic events, especially when taking withdrawals from your portfolio, it's critical to own an asset class that produces a positive return and or moves in a different direction than broad-based stocks. In the academic world, the technical term for this is crisis alpha.

Crisis alpha is the excess return that an investment earns above cash during severe stock market corrections. And historically, during catastrophic events like the COVID crash in 2020 or the Great Recession in 08-09 or the tech bubble bursting in the 2000s, historically, during these catastrophic events, U.S. Treasury bonds have produced significantly higher crisis alpha than corporate bonds.

I've covered this at length during my investing in bonds series. So I'm not going to revisit all the numbers in today's episode, but if you want to re-listen to it, I will link to it in today's show notes.

In addition to isolated events like 08-09, historically AAA rated treasury bonds have also been lifesavers during long time periods where stocks are flat, which I covered recently in episode number 170 titled How to Invest During a Lost Decade. For example, from 2000 to 2009, US stocks were down a cumulative 9%, a negative 9% total return over a 10 year time period. On the

On the other hand, the Vanguard Intermediate Term Treasury Bond Mutual Fund, VFITX, returned a positive 91% during those 10 years, while cash in a high-yield money market only returned 33%.

Without a globally diversified portfolio and an allocation to high quality bonds, a retiree leaning on their portfolio for income during a lost decade like that would have been in a very challenging position. High quality bonds were an absolute lifesaver. But fast forward to this year, a year where stocks were down close to 25% at their low in September and high quality treasury bonds were not that far behind, also down double digits.

Naturally, investors have been scratching their heads wondering why their bonds have not provided the crisis alpha that they were hoping for. And there are two main reasons for this. Number one, this is not an event that we would necessarily define as catastrophic. Yes, a 25% drop in stocks is less than ideal, but

textbook bear markets like this happen about once every six years or so. And as we all know, things can get much, much worse. In the early 2000s, the stock market was cut in half twice. That is catastrophic.

Number two, the Fed has rapidly raised rates and bond yields, while not controlled by the Fed, have increased as a result of this rapid policy shift. When bond yields increase, we see a drop in the market value of our bonds. This is that inverse relationship between yields and bond prices that most of us are aware of. But if that inverse relationship exists, if that's true, then why are bond yields falling following another Fed rate hike?

Well, in short, the interest rate set by the Fed, aka the Fed funds rate, is not correlated to bond yields or future bond returns. I'll say that again. The interest rate set by the Fed, the Fed funds rate, is not correlated to bond yields or future bond returns. The Fed funds rate is the interest rate that banks charge each other to borrow or lend excess reserves overnight. In short, the interest rate set by the Fed, aka the Fed funds rate, is not correlated to bond yields or future bond returns.

It might influence bond yields, especially when the Fed makes a major policy shift and shocks the global markets.

but it doesn't control or decide them. In fact, one study from Dimensional Funds, which I'll link to in the show notes, concluded that over the last 37 years, as far back as they could go for this data, over the last 37 years, there is no reliable relation between past changes in the Fed funds rate and future bond returns. Again, over the last 37 years, no reliable relation between past changes in the Fed funds rate and future bond returns.

So the Fed continues to hike interest rates, yet bond yields are falling. We now know that there's no reliable correlation between the two. So how might we explain why bonds are behaving the way they are right now? Put simply, investors are piling into long-term treasury bonds. And when there's a high demand for long-term treasury bonds, their yields begin to drop.

Why are they piling into long-term bonds right now? Well, because the economy is weakening and inflation is showing signs of cooling, both of which improves the odds that the Fed will likely reverse course and lower rates in the next 12 to 24 months. Remember, the Fed has made it very clear that they are intentionally trying to weaken the economy and drive us toward a recession in an effort to combat inflation, to ensure that we avoid a 1970s style of an event at all costs.

But when the economy weakens, investors tend to flock to safe assets like U.S. treasury bonds. And that flock to treasury bonds, the purchasing of these 10-year treasury bonds, puts downward pressure on their yield. To summarize, the Fed is continuing with their rate hikes to slow down the economy and combat inflation. They appear to be accomplishing their goal with a recession looking more and more likely, and inflation is beginning to show signs of cooling.

With the economy slowing down, investors are buying up safe assets like long-term U.S. treasury bonds, causing their yields to drop even in the face of a rising interest rate environment.

Now that we know why bond yields are going down while the Fed continues to commit to raising interest rates, let's talk more about the current state of bonds, why they're down so significantly this year, and where they might go from here. Again, intermediate-term Treasury bonds are currently down around 11% this year.

And while the Fed funds rate doesn't control their yield, it certainly influences them, especially when there's a rapid shift in the Fed's interest rate policy like we've witnessed this year, where the Fed funds rate has been taken from zero to an upper limit of 4% in less than 12 months through six consecutive rate hikes, six rate hikes in 11 months.

Now, in hindsight, one might say that this policy shift by the Fed was obvious, that interest rates couldn't sit at 0% forever, and it was clear that rates would be increasing. And given how obvious this was, why would anyone choose to own bonds or bond funds over the last year? It's a very fair comment and one that I've heard a lot lately, but I'll let you in on a little secret here.

Not even the Fed knew that the Fed was going to be raising interest rates to this extent this year. You heard that right. Not even the Fed, the organization that sets the level of interest rates in this country, not even the Fed knew that they would be doing what they're doing right now. And I know this because it's public information. The Fed regularly publishes their economic projections for the future, sharing their targets for not just GDP and unemployment, but also inflation and inflation.

interest rates. And in June of 2021, so just a little over a year ago, the Fed projected that the Fed funds rate would be between 0.1 and 0.6 in 2022 and between 0.1 and 1.6 in 2023. In other words, they projected that there might be two to three rate hikes over the next two years. Two to three rate hikes over the next two years is very different than six hikes in 11 months. But

While some market timers might have had their crystal ball working perfectly and successfully predicted this year's events, most people, including the Fed themselves, did not see this coming. And this quick, unpredictable pivot in interest rate policy really shocked the markets, sending bond yields higher and bond prices lower.

So yes, in hindsight, it's easy to kick ourselves for owning bonds. And it's easy to say that we should have seen this coming, sold our bonds and stuffed everything under the mattress. But that would require a crystal ball, a crystal ball that not even the Fed had access to.

For some reason, it's easy for most of us to acknowledge that timing the stock market is impossible and therefore it's best to buy and hold low cost index funds versus actively trading stocks. But when it comes to bonds, cash, CDs, other fixed income instruments, investors often seem more confident about when they can shift in and shift out of these safe asset classes.

And while they are, yes, typically safe asset classes, they are far from simple. And an investor can get themselves into just as much trouble trying to time them as they can with stocks.

So we now know that bonds are down significantly this year because of the Fed's unpredictable rapid policy shift. While the Fed funds rate does not determine bond yields, the rapid increase in interest rates did influence bond yields to follow suit with the 10 year treasury going from 1.77% earlier this year to as high as 4.2%. And

And when bond yields rise this rapidly and significantly, bonds and bond prices suffer losses, losses that are predictable. I use the word predictable here because I'm only talking about AAA rated U.S. Treasury bonds. These bonds, unlike corporate and municipal bonds, don't contain any credit risk, allowing their future returns to be more predictable. Another bonus to owning them in addition to the crisis alpha that we talked about earlier, especially for those in retirement.

Now, while treasury bonds don't contain credit risk, they do contain duration risk, the risk that changes in interest rates will cause their prices to go up or down. For that reason, when we're allocating to U.S. treasury bonds or bond funds, we want to be sure that we match our investment time horizon up with the duration of our bond portfolio.

By doing so, we can fairly easily predict the future performance of our bonds, allowing us to properly build a plan around them. Let me try to break down how U.S. Treasury bonds or U.S. Treasury bond funds are predictable using a hypothetical scenario that more or less represents what we've witnessed this year. Let's say that on January 1st of this year, I put $100,000 into a U.S. Treasury bond portfolio with a yield of 1% and a duration of five years.

And immediately after making this investment, let's say that similar to what we witnessed this year, let's say that bond yields jump to 4% overnight, and then they remain at 4% for the next 10 years. So $100,000 on January 1st into a U S treasury bond portfolio yield of 1% duration of five years. Immediately after doing this yields jump 4% overnight, and then stay at 4% for the next decade.

Well, this jump in yield, this rapid jump in yield from 1% to 4% overnight would cause the value of my bond portfolio to drop by almost $14,000. My $100,000 would now be worth $86,000 and change due to the immediate rise in yields.

But guess what? Now my bond portfolio with a duration of five is paying a higher yield. And since we're assuming yields don't move again in this very simple example, I know with certainty that in exactly four years, my bond portfolio will have recovered. And by year 10, my $100,000 investment would be worth almost $128,000.

On the other hand, if bond yields never changed after making my $100,000 investment and rates just remained at 1% throughout the same 10-year time period, I wouldn't have had to deal with a significant price drop in those first few years. However, I would have also ended the 10-year time period with significantly less money. My bond portfolio in this example where rates just stick at 1% and don't change would

would only be worth about $110,000 in year 10 versus that $128,000 I mentioned earlier. In the short term, the duration risk I was taking certainly hurt a little bit, but the higher yield over the remainder of my investment time horizon quickly made up for those early losses.

Bringing this back into today's current situation where intermediate term U.S. treasury bonds are down about 11%. Yes, I know it's not fun to see our bonds down double digits, but we now know that we will recover from those losses in just a few short years, even if yields don't change as those higher yielding bonds begin to pay us higher coupons. Assuming we own AAA rated U.S. government bonds, our future returns are actually quite predictable.

The real problem or risk that exists is if your bond duration, your bond portfolio's duration is longer than your actual investment time horizon. For example, if you bought U.S. Treasury bonds as a cash equivalent for your emergency fund...

You'll likely be forced to sell your bonds at a loss if you wake up tomorrow and need a new roof on your house or you have an unplanned medical emergency. But if your duration is matched up with your time horizon, you can simply acknowledge that, yes, it's painful to see our bonds perform like this in the short term. But then remind yourself that it's fairly easy to figure out when they will recover, assuming they're U.S. Treasury bonds and not riskier corporate or municipal bonds that contain credit risk.

Now, you might already be thinking this, but bonds can also recover if their yields go down. When their yields go down, bond prices go up. And that's what we've seen since the Fed last raised interest rates on November 2nd. As I stated earlier, 10-year treasury bond yields have actually fallen since the Fed last increased rates. And this drop in yield has sent the Vanguard Intermediate Term Treasury Bond Fund up by about 2% just this month.

So if investors continue to pile into U.S. treasury bonds, sending their yields even lower, it might only take months for your bond portfolio with a duration of five to recover versus four years like the example I walked through earlier.

And that's where things get a little less predictable here in the real world. We know how a treasury bond portfolio will perform when the yield changes, but we don't know when and how yields will change. That lack of certainty in future yields is precisely why I think retirement savers should continue to own bonds, specifically plain vanilla U.S. treasury bond funds, even in light of this year's historically poor performance.

We don't know what is around the corner and what will happen in the future. And while interest rates likely won't go back to zero unless something really crazy and catastrophic happens, it wouldn't be totally out of the realm of possibility for 10-year treasury yields to drop by, I don't know, 20% to 40% from current levels as it looks more and more likely that the Fed is accomplishing their goal of steering us toward a recession.

If that were to happen, your boring U.S. Treasury bond fund is going to be a lifesaver for your portfolio, especially for those relying on their investments to produce a regular retirement paycheck. And if that doesn't happen and rates remain at today's level and don't change, well, we still know with certainty how long it will take for our AAA-rated Treasury bonds to recover and what their future long-term returns will be.

Okay. Lastly, before we part ways today, one question continues to come up when talking about bonds and bond funds and their current performance this year. And that is if investors should consider bank CDs instead of volatile bond funds going forward. And it's a good question because banks are advertising very attractive CD rates at levels we haven't seen in years. And it's not surprising that investors are responding positively to these offerings given how starved for yield they've been.

But there are five things to take into consideration when considering CDs as a bond fund alternative. Number one, if you buy into a five-year CD ladder, and I say a five-year CD ladder because that's typically the longest I'll see people go. So if you buy into a five-year CD ladder or build one yourself, the duration of your CD portfolio will be about two and a half years.

In other words, when compared to a U.S. Treasury bond fund that has a duration of five years, you have to expect a lower future rate of return, lower duration, lower rate of return. And therefore, with a lower rate of return, you might have to reduce your withdrawal rate if you're leaning on your investment portfolio for income in retirement.

Number two, on that note, buying bank CDs and spending the interest earned is a totally different philosophy than buying and holding bond funds that are part of a globally diversified portfolio. The former is what we call an income approach, and the latter is my preferred methodology, which is often called a total return approach.

With an income approach, you spend the income earned from your investments and don't touch the principal. With a total return approach, every investment in your portfolio is working together with dividends and interest payments being reinvested in an attempt to appropriately manage your risk and target a desired long-term return.

Unlike the income approach, withdrawals using a total return approach are based on an identified sustainable withdrawal rate, and the withdrawals are pulled each month or each quarter from the highest performing investments first. And while there are strong arguments for both philosophies, Vanguard has published a few articles and studies that conclude that an income approach to investing leads to an inappropriate risk exposure to

for investors and that a total return approach is quote, a superior approach for income investments. Vanguard also states that a total return approach helps to minimize portfolio risks and maintain portfolio longevity while allowing an investor to meet spending goals with a combination of portfolio income and capital.

While Vanguard's conclusions are certainly compelling, the most important thing to me is that you find a philosophy that you agree with and stick with it for the long term. So if income investing is your preferred methodology to producing income in retirement, then sure, buying and laddering individual CDs or even individual bonds would certainly support that.

Number three, with CDs, you're giving up crisis alpha that historically has been delivered by high quality treasury bonds during catastrophic events. And in retirement, that crisis alpha can be very much needed to sustain long-term withdrawals from the portfolio, especially in the first 10 years of retirement.

Number four, buying a AAA rated bond fund with a duration that matches your investment time horizon also helps to remove the guesswork and more importantly, the emotions of investing. If I'm buying and laddering bonds or CDs, I'm forced to make a decision every time one of those holdings matures.

Depending on the interest rate environment at that time that the holding matures and depending on how I'm feeling on that given day about my financial situation or the state of the economy or where rates might be going next, well, I might be lured into making a market timing decision that can hinder my future returns.

The good news is that there are automated services that can do all this for you, which will help to ensure that you don't get in your own way if this is the route that you choose. Still, don't forget about point number one, that the duration of your laddered CD portfolio is likely lower than an intermediate term treasury bond fund, meaning you might have to expect lower future rates of return.

And then lastly, number five, bank CDs can be callable, meaning the bank can give you your principal back before your maturity date, forcing you to go and buy a new CD at likely much lower rates. They wouldn't call your CD if rates went up. This usually happens when rates go down from where you purchased.

In any event, callable CDs and callable bonds can cause your future returns to be less predictable. And while it doesn't mean that you should avoid bank CDs at all costs because of this, it's just important to look under the hood and understand if the CDs you currently own or you're considering are callable so that you can take that into consideration in your planning.

In conclusion here, bank CDs can be a great choice, but to me, they are primarily a cash alternative. When considering them as a bond fund alternative, there are just a number of important nuances that we just went through to take into consideration before just jumping in feet first.

As noted at the top of the show, the bond market is wildly complex, which just like the stock market leads me to conclude that trying to predict the future of bonds and interest rates is a losing game in the long run. That trying to time the bond market or pretend I know when it's best to own a bond fund versus a bank CD or cash under the mattress is likely going to lead to lower future returns.

It's been an extremely challenging year in the market, especially for bond investors who had very different expectations from their fixed income investments. But just like any other downturn in the markets, it's important that we stay committed to the plan that we worked so hard to put into place and trust the process. Be patient, stay the course, continue to get curious and study history, and most of all, stay focused on investing for the next few decades, not the next few months.

Once again, to grab the links and resources mentioned in today's episode, just head over to youstaywealthy.com forward slash 172. Thank you as always for listening. Have a wonderful Thanksgiving and I will see you back here next week.