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Since August 1st of 2020, investment-grade bonds are down 24%. Even worse, long-term treasury bonds are down almost 50%. And if those losses aren't enough to cause frustration, the U.S. stock market is up 30% during the same three-year time period. What the is happening to bonds right now? Why are safe asset classes down double digits while risky asset classes scream upward? Should
Should retirement investors make changes to their bond portfolio? Are money markets and CDs a better solution than bond funds? And what might all this mean for the future of the bond market? Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte, and today I'm kicking off a two-part series to help answer these questions. I'm also sharing an actionable tip for improving your asset allocation if you're struggling to determine what to do with your bonds in this current environment.
For all the links and resources mentioned today, just head over to youstaywealthy.com forward slash 203. In the fall of 2020, I published a four-part podcast series breaking down this asset class. I covered the pros and cons of individual bonds versus bond funds, the primary drivers of bond returns, why holding bonds to maturity isn't always prudent, and how to invest in bonds. If you want to revisit that series, I'll link to it in today's show notes.
But I'm also going to share some of the research from that series here today to help support some of the big questions that retirement investors are asking right now about bonds. So if you don't feel like going back into the archives, don't worry. This short two-part series will bring some of the highlights back to the surface. Okay, to kick off part one today, let's first quickly revisit what bonds are and why someone would want to include them in their portfolio.
So as most know, when you buy a stock, you're taking an ownership stake in the company that you're investing in. A very, very, very small ownership, but an ownership nonetheless.
Bonds, on the other hand, are loans. It's kind of confusing, but when you buy a bond, you're actually loaning your money to someone, a corporation, municipality, or the government. In return, they're paying you an interest rate during the term of your loan, and if all goes as planned, they'll return your original loan back to you at the end of the term or maturity. For
For example, let's say you buy a five-year $100,000 bond issued by ABC Corporation that's paying 5%. In this oversimplified example, ABC Corporation will pay you 5% every year for five years, so a total of $25,000, and then return your original $100,000 back to you at the end of year five.
Now, the interest rate that you receive on the bond that you purchase will depend on the risk profile of the company or institution that you're loaning your money to. Smaller, unknown corporation needs to borrow your money to fund their operations? Well, they'll need to pay you a higher interest rate to compensate you for that risk. That risk, of course, is that they don't make it and you don't ever see your original loan back ever again.
With a basic understanding of what bonds are, let's move into why someone might buy and own bonds as part of their investment strategy. So in short, I'm going to say that there are three different reasons why someone might buy and own bonds. Number one, for some, bonds are speculative. They're bought and sold every day, week, or month in an attempt to outsmart the markets and make a quick buck. Not all that different than a stock trader.
Number two, for others, bonds are used to improve risk adjusted returns during the accumulation phase of life. In other words, sprinkling in some bonds to a diversified portfolio can actually help reduce risk while improving long term returns over long periods of time.
And then finally, number three, for clients like mine who are in retirement or close to it, high quality bonds are used primarily as a diversifier or stabilizer in the portfolio, not necessarily to boost returns. If a client needs or wants higher long-term returns, well, we would allocate more to stocks than to bonds. As always, the more risk you take, the higher of a return you can expect.
Speaking of risk, just like stocks, bonds and bond funds contain different risk profiles that investors need to be aware of. There are risky bonds, safe bonds, and everything in between.
For example, corporate and municipal bonds typically pay higher interest rates or yields and have higher expected returns than U.S. Treasury bonds. And that's because, well, they're riskier. Unlike Treasury bonds, corporate and municipal bonds contain additional risks such as credit and liquidity risk.
In other words, there's a risk that a corporation you loan money to can't pay it back, or they might be going through a tough time when you need or want to sell your bond and you can't get the price that you were hoping for.
Once again, to compensate you for these risks, the issuers will typically pay you a higher interest rate. Not all that different than you commanding a higher interest rate when loaning money to a friend who can't keep a job or has a bad track record of paying loans back. You would want to be compensated fairly for taking that extra risk. In addition, the more risk you take with bonds, the more they typically begin to behave like stocks during catastrophic events.
And during catastrophic events, especially when you're taking withdrawals from your portfolio to fund retirement expenses, it's critical to have proper diversification. It's critical to own an asset class or asset classes that have low correlation to broad-based stocks. In other words, you want something in your portfolio to help stabilize things and maybe even earn a positive rate of return when traditional stocks collapse.
In the academic world, the technical term for this is crisis alpha. And historically, during catastrophic events, AAA rated US Treasury bonds have produced significantly higher crisis alpha than their riskier counterparts.
Like any investment, stocks, bonds, real estate, cash, the reason for owning bonds and the types of bonds an investor chooses to own depends on the investor's risk profile and more importantly, their long-term goals.
Because as previously mentioned, bonds are not riskless. Even safe U.S. treasury bonds bought and held to maturity contain risks. They don't necessarily contain credit and liquidity risks like corporate or junk bonds, but they contain interest rate or duration risk, inflation risk, and reinvestment risk. And we're seeing some of those risks appear in real time right now, even with the highest rated bonds in the world.
Since August of 2020, intermediate-term Treasury bond funds are down between 15% and 20%. Why are safe U.S. Treasury bonds down between 15% and 20% in the last three years? Let's unpack this. So while the Fed doesn't control bond yields, it does influence them. And in response to the Fed rapidly raising the Fed funds rate in recent years, bond yields have followed suit.
And when bond yields rise, their prices fall. There's an inverse relationship that most investors have at least heard of before. This inverse relationship is talked about a lot, but it's not typically explained or explained very well. So why exactly would bond prices fall when interest rates or yields rise?
Well, let's say last year I bought a five-year $100,000 treasury bond that pays me 2%. And then unfortunately for me, interest rates jumped shortly after buying my bond. And here in 2023, one year later, all new five-year treasury bonds issued in the market are now paying 4%.
I'm stuck with my five-year bond paying 2% while everyone else gets to buy the same five-year bond at 4%. All of a sudden, my bond doesn't look too attractive. So if I try to sell you my bond for the $100,000 I paid for it, you wouldn't do it knowing that you could just go buy a newly issued five-year bond that pays double what mine is paying.
The only way you might consider buying my bond is if I sell it to you at a discount and realize a loss on my investment. For example, instead of selling it to you for the $100,000 I paid for it, I might have to sell it to you for, let's say, $85,000. You buying it for $85,000 would be a fair deal because if you hold it until maturity, you'll get paid back the original $100,000 on top of the 2% interest that you collected along the way.
The same logic in math applies to bond funds. It's just occurring across thousands of bonds instead of just one. So if you bought your bond fund in 2020 and tried to sell it today, you would have to sell it at a discount and realize a loss, just like I did in my example.
The difference with the bond fund, which we'll dig into more here in a minute, is that your bond fund yield is higher because bonds are regularly maturing inside the fund and being reinvested at today's current rates. So if you don't panic and sell it and take a loss, you'll receive today's higher yield and begin to recoup those paper losses.
Quick side note, some people have questioned why anyone would have owned bonds in their portfolio three plus years ago when interest rates were so low.
With their 2020 hindsight glasses on, they said it was obvious that interest rates and in turn bond yields would go up, and therefore bonds were guaranteed to fall in price. However, as I shared in my episode on bonds titled, Should Retirement Savers Own Bonds? Not even the Fed knew that the Fed was going to raise rates to this degree, and
And I know this because the Fed publicly shares their targets for not just GDP and inflation, but also interest rates. And in June of 2021, 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. For context, today, the Fed funds rate sits at 5.33%, more than twice as high as the Fed's expectations.
While some market timers might have had their crystal ball working perfectly and successfully predicted all of the events that would follow a global pandemic that caught everyone off guard, most people, including the Fed themselves, did not see this rapid spike in interest rates 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. And then, of course, we have to make sure that our crystal ball is right twice. We not only need to have sold our bonds at the perfect time, but we then need to know when to buy back in.
For some reason, it's easy for many investors to acknowledge that timing the stock market is impossible, and therefore, they agree that it's best to buy and hold low-cost index funds versus actively trading stocks. But when it comes to bonds, cash, and CDs, investors seem more confident about when to shift in and out of these safe asset classes. And
And while they are typically safe asset classes, or at least safer and less volatile than stocks, they're far from simple. An investor can get themselves into just as much trouble trying to time bonds as they can with stocks. Okay, quick recap before we go any further. First, not all bonds are equal. There are risky bonds, safe bonds, and everything in between. Next, the reason for owning bonds depends on the investor and their unique needs and goals. Number
Number three, bond yields have spiked rapidly, sending bond prices down in the last three years. Number four, trying to time the bond market is just as dangerous as trying to time the stock market. And finally, number five, as always, while not everyone shares my philosophy, and that's okay, I personally do not believe anyone has a crystal ball that consistently predicts the future. And I especially do not believe anyone has a crystal ball that predicts it accurately twice.
So I've mentioned a couple times now that bonds are down double digits in the last three years because interest rates or yields have spiked. In my experience, most investors get stuck on the former bonds being down and don't consider the latter yields being up. Yes, your safe intermediate term treasury bond fund has dropped in price over the last three years.
But it also now has a higher yield. Higher yield means higher future expected returns. And the great thing about investing in U.S. treasuries versus other riskier bonds is that their risk return profile is fairly predictable. More specifically, the duration of the treasury bond or treasury bond fund that you invest in tells you everything you need to know about how it will respond to changing yields and its future expected returns.
While the same math applies to other types of bonds, there are other unpredictable risks that we touched on earlier with those riskier bonds that can disrupt that math. So it's just not as reliable.
So again, the duration of treasury bonds or a treasury bond fund tells us everything we need to know about how it will respond to changes in bond yields. Put simply, bond duration is a way of measuring how much bond prices are likely to change if and when yields move.
For example, if yields were to rise 1%, a bond fund with a five-year average duration would likely lose approximately 5% of its value. If the duration was longer, the loss would be greater. If the duration was shorter, the value lost would be lower. Of course, just like stocks, you can't have your cake and eat it too. If you want less interest rate or duration risk...
you have to accept lower yields and returns. Once again, how a bond portfolio is constructed depends on the risk return profile and goals of an investor. There is no free lunch here.
By the way, to find the duration of your bond fund, just head to the fact page for the fund that you own or punch the ticker symbol into Morningstar.com. It's a transparent number that's very easy to locate and is something that every investor who owns bonds or bond funds should take note of.
Okay, with that basic explanation of the relationship between bonds and interest rates, let me share a quick example that really isn't too far from the current situation we're in right now to help illustrate how bonds work and how we can set proper expectations with our bond investments. So let's say I put $100,000 into a bond fund that is yielding 1% and has a duration of 5 years.
And let's say there are two potential scenarios that could occur in the future after I make this investment. In scenario one, interest rates stay low forever. COVID never happens. We remain in this low interest rate environment. And I just continue to clip my 1% yield.
In this scenario, by the end of year five, my bond fund investment slowly grows from $100,000 to $105,000 and change. I didn't make much money, but also didn't suffer through any volatility or experience any losses.
On the other hand, in scenario two, the economic environment changes rapidly on me. The Fed changes their low interest rate policy overnight. The yield on my bond fund immediately jumps to 4% and then remains at 4% for the next 20 years.
Now, because my bond fund, as I mentioned, has a duration of five, the immediate spike in yields causes my $100,000 investment to drop to $86,000 and change on the first day of trading.
In one day, I lose almost $14,000 in my safe AAA rated US treasury bond fund. But I don't need access to this money. I bought this fund because my time horizon is greater than five years for this investment bucket. So while losing $14,000 in one day is not fun, I'm aware that my bond fund is now paying me 4%.
Now that I'm earning a higher interest rate, my investment begins to claw back and ends year one at close to $90,000. By the end of year two, it ends the year just over $93,000. Year three at $97,000. Year four, I break even at just over $101,000.
And finally, at the end of year five, because of this new 4% yield, my original investment that lost $14,000 on day one is now worth $105,000 and change.
If you're following, that's the exact amount that I had at the end of five years in scenario one, where interest rates remained at 1% and never moved. In other words, my break-even point here was at the five-year mark, the duration of my bond fund. It was a bumpy ride to get there, but that was a transparent risk that I knew I was taking when I purchased a bond fund with an average five-year duration.
So why would I opt for scenario two? Why would I willingly buy a bond fund with a five-year duration that would take me on a wild ride only to break even with scenario one in five years? Well, because I'm a long-term investor and in scenario two, I have a bond fund paying 4% that crossed the break-even point and is now compounding at that rate every single year.
By the end of year 10, my bond fund in scenario two is worth almost $128,000. The same fund in scenario one that's still slowly clipping 1% is only worth $110,000 at the end of year 10.
And by the end of year 20, scenario two is worth roughly $190,000 while scenario one just barely crosses $120,000. Not only did I end up with a healthy rate of return during that time period, but I didn't have to spend my valuable time jumping in and out of individual bonds, praying that reinvestment risk doesn't disrupt my target return.
We haven't talked about reinvestment risk much yet, but this is another danger that individual bond and CD investors face. Reinvestment risk is the risk of having to reinvest proceeds of a bond or CD that's maturing at a lower rate than what the funds were previously earning. With a low cost, high quality bond fund, I own thousands of bonds at basically no cost that are all constantly maturing and being reinvested at new current yields.
If I own a handful of individual bonds, I have to wait for my next bond to mature before I can reinvest. And who knows what rates will be doing while I wait for that next maturity date.
Even worse, my bonds could be what's called callable, and the issuer could give me my original loan back early because rates dropped and they're no longer interested in paying me the original interest rate. So I ended up with a much healthier return in scenario two over the long term without really doing much other than staying the course after losing $14,000 in one day.
But the point here is not to make an argument for taking risks with your bonds or suggest that it doesn't matter if you experience double digit losses in the near term, like many bond investors are experiencing right now.
The point is that investors need to match their risk and bond duration with their investment time horizon. In other words, if an investor has a three-year time horizon for a particular bucket of money, then they shouldn't allocate that bucket of money to a bond fund with an average duration of five. An investor's time horizon should match up with or be greater than the duration of their bond investment.
Going back to where we started this episode, the Vanguard Total Bond Market Fund, one of the largest bond index funds in the world at close to $300 billion in assets, has an average duration of about six years. So if an investor bought this fund in August of 2020 and currently finds themselves down about 24%, it's worth highlighting that this was a transparent risk they knew or should have known existed.
And hopefully their time horizon for the money invested in this fund is greater than six years, because if it is, then they should be excited about the current 5% yield and higher future expected returns. And they should do their very best to ignore the performance here in the short run.
Not all that different than investing in the stock market. Most investors know that anything can happen to our stocks within a 10 to 15 year time period and wouldn't or shouldn't take risk in the stock market with money that they need access to in the short term. And this is precisely why diversification is so important.
In addition to ensuring that everything we own is not highly correlated, we want to ensure that we have investments earmarked for short, intermediate, and long-term needs. Now, just because we have these proper investment buckets established doesn't mean that they always perform how we would expect them to in the short term.
Thank you.
It's anyone's guess how each asset class will perform month by month, year by year, which is why diversification and matching our time horizon with our different investment buckets is so important. It's
It's also why I'm an advocate for total return investing. Instead of solely relying on yield, a total return investing strategy allows investors to spend from appreciation in the total portfolio, rebalancing the different holdings based on current year performance.
In summary, if your investment-grade bond fund has lost money in recent months or years, it's not because you made a bad investment or that bonds are bad or that you should sell it all and buy bank CDs instead. It's just that the risks contained in the bond fund that you own, risks that should have been taken into consideration, they showed up and they showed up rather quickly, catching many investors off guard.
We've experienced rising interest rate environments before, but they haven't always been this quick and extreme. For example, in 1950, long-term U.S. government bonds yielded just over 2%.
By 1960, those yields jumped up to 4.5%. By 1970, they were at 10%. And by 1981, they reached 15%. So yields jumped from 2% to 15% in roughly 30 years. Even knowing what you know now, you'd likely still guess that bonds lost a lot of value during this time period of rising rates.
But that's not the case. Long-term government bonds had an average annual return just over 2% and had a cumulative return just over 90% during that time period. As Ben Carlson put it, this time period was more of a death by a thousand cuts. The change in rates was gradual, which is not what we've experienced in the last three years. And personally, I'm not sure what's worse or what's easier for an investor to manage from a behavioral perspective.
Thank you.
But unlike most areas in our life, when it comes to investing, taking action and making dramatic changes to our portfolios typically hinders our long-term goals. As Jack Bogle once said, don't do something, just stand there. But let's say an investor feels inclined to do something. Let's say that they don't have the proper portfolio and the bonds that they own don't match up with their risk, their time horizon, and or their retirement goals.
What should those investors do to get their investments back in line? And what about money markets yielding 5%? Is that a good bond alternative for those that don't want to take duration risk? And finally, what does the future of bond investing look like? Does the current interest rate environment shift how retirement investors should approach this asset class going forward? I'll be tackling those questions and more next week in part two of this two-part series on bonds.
To grab the links and resources supporting today's episode, just head over to youstaywealthy.com forward slash 203. Thank you as always for listening, and I'll see you back here next week.
