Originally published in North Bay Business Journal
For investors, it has been a trying year: Both stocks and bonds have been down at the same time, which is not common. It is quite rare for bonds to be down in any material way during periods of stock market decline. To put this into perspective, the current level of declines in portfolios holding both stocks and bonds is among the worst in history. We hold bonds in portfolios primarily because they help to soften the sharper edges of stock market volatility. Most of the time when stocks are down, bonds are up (or only experience relatively modest declines). In the past 46 years, over a calendar year, bonds produced a positive return 90% of the time (42 out of the 46 years). Prior to this year, the next largest 12-month decline (i.e., including intra-year declines) was in 1980 when bonds (as measured by the Bloomberg Aggregate Bond Index) went down by 9%. The market ended that calendar year up by 3%.
So, the big questions are: Why are bonds acting this way and what are their prospects going forward?
The driver of these declines has been the swift rise in interest rates. When interest rates go up, the value of underlying bonds goes down. Bonds are simple on the surface, but complex in the real world. For many, the environment we find ourselves in might not make sense. If interest rates are going up, then am I not making more in interest income? Earning 4% is obviously better than earning 1%. The problem comes when you try to sell that 1% bond; it will not appear very attractive to a potential buyer when they know they can get 4% in a similar bond issue.
A Bond Math Primer: Why Bonds Go Down in Value
At the risk of becoming overly technical, let’s do some math to show what we mean. On January 1, 2021, let’s imagine that you bought a one-year bond the day that it was first issued for $1,000 and it earns 1%. After one year you will have earned $10 in interest income (1% of $1,000 = $10) and you will get your $1,000 back. That is a 1% return. Simple, right? But what happens if you need cash, and you decide to sell the bond seven months after buying it? And during that seven-month time period rates for similar bonds have gone up to 4%. If you try to sell the bond for what you paid for it (i.e., $1,000) no one would buy it. Think about it: if you were a buyer in the market and had $1,000 and you could choose between two investments of equal risk characteristics and one earned $10 and the other $40, why would you pick the lower one? No one would choose 1% when they could get 4% on the same initial investment. In this scenario, does this mean you are stuck with your bond? Not necessarily. What you then do is lower your price in such a way that the buyer would earn 4% or $40. In this case, you would have to sell the bond for $982.97. In mathematical terms, the buyer is indifferent to spending $1,000 on a new issue bond that earns 4%, or $982.97 on a bond that earns just 1%. Both end up earning 4%. It is just math. For the seller, that would represent a 1.7% loss. And this is what is happening across the board in the bond markets. Interest rates are going up and investors who currently own bonds are seeing losses – though only on paper. And this is another important concept: If the original investor just holds that same bond until it matures, he or she would never experience a loss. They would earn their $10 and get their $1,000 back, which they can then reinvest at 4%.
How We Design Your Bond Portfolio
Most of our clients’ bonds are held in mutual funds. These are highly diversified funds that are typically comprised of thousands of individual bonds with a range of maturities (that is, they come due on many different dates). Some funds are comprised of US Government Treasuries (considered to be among the safest investments in the world) and others are of high-quality US corporate issues. We work with the largest and most experienced fund managers in the world. This is important because while the bond market is huge (many times larger than the US stock market), it is very opaque. As a result, if you do not follow it minute by minute and know who owns what bond where for what price, it is very easy to buy at less-than-optimal prices. Or to put it another way, unless you are a professional bond trader, it is very easy to make mistakes or get taken advantage of. We are very disciplined in our strategy. In our bond portfolios, we focus on making sure we only hold the highest quality bond issues. And we typically own bonds that are shorter on the maturity range: Our bond holdings range from less than one year to rarely more than seven years. Bonds with shorter maturities are less susceptible to the negative impact of rising interest rates because they are coming due faster and being reinvested at the now higher rates. We do not “reach” for yield. What this means is that we do not take extra risk in an attempt to eke out a bit more return. We do not invest in long-term bonds (these are highly susceptible to interest rate changes) and we do not invest in “high yield” bonds (aka “junk bonds”). Our bond holdings are in the portfolio to reduce overall risk and dampen volatility. They are not intended to amplify returns over the long run. The past nine months have been rough on bonds, and they have not been as effective as we would prefer in their overall portfolio impact. We know this is a frustrating time. No investment strategy over the past year has been rewarding – there has been no place to hide. But we know that bonds represent a better value now and have a higher expected return than they have in many years. Your yields are getting better – in fact, they are reaching levels not seen in over 14 years. The bonds you held that earned less than 1% in the spring are now earning 4%. And the underlying prices reflect that the Federal Reserve plans to raise rates by at least another 1.25-1.75 percentage points in the coming months. In other words, like stocks, bond pricing incorporates all the known and available news. Let the markets do their thing, as we can’t control them. As always, our advice is to not react to short-term volatility and to stay true to your investment plan.