Do Bonds Have a Future?

As financial events go, this one was pretty reliable. When stocks went down, the value of your bonds went up. Sure, the bonds didn’t rise enough in value to offset a big market decline, but at least something was looking up.

In the “flash crash” of 1987, for instance, the entire stock market lost 22.6 percent between Sept. 3 and year end. During the same period, the total bond market rose 5.9 percent. Bond holdings didn’t eliminate pain, but they reduced it.

That investment truism died earlier this year. Some would say it died earlier than that.

Since Jan. 3, major stock indexes have declined. Tune into some of the talking heads to hear the list of lamentations. But in the first quarter of this year, the Vanguard total stock market index declined by 5.4 percent, while the Vanguard total bond market index fell 5.85 percent. Nothing has improved since.

So, when the paddy wagon came, it took the bonds too. Worse, with interest rates still low and dwarfed by inflation, it’s hard to hold out hope for bonds as an investment. If interest rates rise, as most expect, bond prices will drop. If interest rates don’t rise, you’ll still lose purchasing power to inflation.

Does this mean bonds are dead?

Well, let’s just say they are in a coma. Barely alive and losing ground. It doesn’t look good.

You can understand this with a quick lesson in bond pricing. If you own a bond that earns 2 percent and interest rates on new bonds rise to 4 percent, investors won’t buy your 2 percent bond at the original price because they can get more interest income from a newer bond.

If you want to sell your bond, it will have to be priced to provide the new investor with a 4 percent yield. Exactly how much the price has to go down depends on how long you are stuck with the lower yield on the old bond. If the bond matures in a year or two, the damage won’t be so bad. But if it doesn’t mature for 10 or 20 years… well, then it can be priced down enough to make it drop like a bad stock.

You can test this out for yourself by using one of the many online bond calculators. Here are some examples from the Omni Bond Price calculator.

• If you owned a $10,000, 2-year Treasury yielding 0.78 percent at the start of this year, that Treasury would now be priced at $9,614, a loss of 3.9 percent, to reflect the current interest rate of 2.78 percent.
• If you owned a $10,000, 10-year Treasury yielding 1.63 percent at the beginning of the year it would now* be priced at $8,848, a loss of 11.5 percent, to reflect the current interest rate of 2.97 percent.

In both cases you’ve suffered a loss in value and then paid taxes on a yield far below inflation.

But that’s old news. The big question for the future is how high will interest rates go? No one knows. All we know for certain is that inflation, most recently at a trailing rate of 8.5 percent, is reducing the purchasing power of all fixed-income investments because it’s wildly higher than interest rates at all maturities.

The table below shows the Treasury yield curve for maturities of 1 year to 20 years.  In the line below that, I’ve assumed an across-the-board yield increase to 5 percent. This is not a prediction. It’s less than the trailing rate of inflation.  It’s entirely reasonable in historical terms. But few economists are predicting rates will go this high.

To complicate things a bit more, interest rates don’t rise in concert. Typically, the shorter maturities rise, or sink, more than the longer maturities.

A lower line in the table shows the percentage loss at each maturity from a rate increase to 5 percent. It’s not a pretty picture. For the 10-year Treasury that began the year at 1.63 percent, an increase to 5 percent would mean a loss of 26.3 percent.

As I write this, the yield has already reached 2.97 percent.

Will it continue to 5 percent? I have no idea. But unless inflation is less than 5 percent for the year, you’ll still be losing purchasing power to inflation.

This is a pretty good indication that fixed-income investments aren’t going to be very rewarding in the next year. Or longer.

What can you do to protect yourself?

Not much. Our government, under both parties, has favored borrowers over savers by suppressing yields for more than two decades. Increasing interest rates won’t change that until interest rates are higher than the rate of inflation.

Until then, it’s all about limiting the speed we lose purchasing power.

The simplest move is to sell any bond holding that has relatively long maturities and replace it with a very short term holding. For instance, if you hold any of the ETFs such as Vanguard Total Bond Market Index (ticker: BND), iShares Core Aggregate Bond ETF (ticker: AGG) or Schwab U.S. Aggregate Bond ETF (ticker: SCHZ) that try to duplicate domestic bond market, you can replace it with an ETF like the iShares Short Treasury Bond ETF (effective maturity according to Morningstar 0.37 years, ticker: SHV). Another alternative, which is coming back after years of hibernation, is money market funds.

Think of it as holding your breath and waiting.

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Sources and References:

U.S. Treasury: Daily Treasury Par Yield Curve Rates, Q1 2022 https://home.treasury.gov/resource-center/data-chart-center/interest-rates/TextView?type=daily_treasury_yield_curve&field_tdr_date_value=2022

Omni Bond Price Calculator: https://www.omnicalculator.com/finance/bond-price

Portfolio Visualizer, Backtest Portfolio Asset Class Allocation: https://www.portfoliovisualizer.com/backtest-asset-class-allocation#analysisResults

Barry Ritholtz, “The Death of Equities,” Business Week, 8/13/1979

https://ritholtz.com/1979/08/the-death-of-equities/

This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

Photo: Scott Burns, A Quiet Cove Near Annapolis, summer 2022

(c) Scott Burns, 2022