It is a time-honored tradition that having bonds as part of a diversified portfolio is important, particularly as we age. Young investors can eschew bonds if they are willing to ride out the ebbs and flows of the stock market, but as we get into our 40s and beyond, it is common, and often necessary, to inject them into the equation. But there has been recent turmoil in the bond market, also known as fixed income, driven by the prospect of rising interest rates, something that is important for all investors to understand.
First, a little history. For those of us in our 60s and beyond we’ll remember the interest rate environment of the late ’70s and early ’80s. Inflation was a serious scourge, topping out at almost 14% — much worse than our current challenge and interest rates reflected that. Mortgages, yields on bonds and CDs were in the double digits.
The chairman of the Fed at the time, Paul Volcker, made it his mission to tame inflation with draconian efforts by raising the federal funds rate to a peak of nearly 20%. It worked. Inflation came down dramatically in the ’80s and continued to drop overall for the next three decades.
What Rising Rates Do to Bonds
This brings us to the important, but difficult, topic of how interest rate movements impact bond portfolios. The direction of interest rate movement has the opposite effect on the value of a bond held in a portfolio. The reason is as follows: If I own a $10,000 10-year U.S. Treasury note I purchased two years ago that has a yield of 2%, the value of that note and the amount another buyer is willing to pay me for it are directly tied to what a new note would be worth to that investor. So, if that buyer of my note yielding 2% could get a new note paying only 1% from the U.S. Treasury, they are willing to pay me more to get my higher yield. Conversely, if that investor could buy a new note and get 3%, my 2% note is of less value to them.
If the general direction of interest rates since the 1980s has been down, bond portfolios have therefore done very well in terms of returns. The Bloomberg US Aggregate bond index had an annual average gain of 7.41% from 1980 to 2018. The largest decline was -2.92% in 1994.* If we depart the low interest environment we’ve enjoyed for so long, which may finally be happening as we speak, bonds will likely have more challenging quarters ahead. We have seen exactly that this year. For context, the Bloomberg US Bond Aggregate index is down 7.89% YTD to April 8, 2022.**
It is also important to note that not all bonds are alike. There are many types of bonds, including government, corporate, inflation-protected securities, municipal and mortgage bonds. They can also vary in length: Some bonds are issued for a short period (one to two years), while others are issued for 30 years or longer. Corporate bonds can be issued by stable companies that have a lower possibility of default and, therefore, lower yield, or by struggling companies willing to offer a higher yield to the investor, but with much more risk. A 30-year U.S. Treasury note has more interest rate risk than a two-year note. Well-managed funds and ETFs have recognized these trends and position portfolios to try to mitigate these risks.
So Now What?
Does that mean bonds are no longer an important piece of a diversified portfolio? Not necessarily, but the question is timely. We need to reset our expectations and consider certain types of bonds. Increased allocations in short-term bonds, inflation-linked bonds and possibly an increase in cash positions are ways to recognize this challenge and reduce the risk. Bonds held in mutual funds and ETFs will go through ebbs and flows. As interest rates go up, new bonds purchased into the funds will have a higher return, eventually providing more yield to the investor, but the transition from this low-rate environment to a more reasonable plateau, whatever that may be, could be a bit rocky.
I often remind my clients that investing is an amusement park: Stocks are the roller coasters, bonds are the bumper cars and tilt-a-whirls. That is, they give you the uneasy feelings, just not as much as the roller coaster of stocks. Cash, such as money market funds and savings/CDs, are the merry-go-round. Navigating these different savings vehicles can be challenging, and priorities are ever changing. Learning about interest rates and their impact on bonds especially can help make your decisions educated and informed.
Jamie Letcher is a Financial Adviser with LPL Financial, located at Summit Credit Union in Madison, Wis. Summit Credit Union is a $5 billion CU serving 176,000 members. Letcher helps members work toward achieving their financial goals and through a process that begins with a “get-to-know-you” meeting and ends with a collaborative plan, complete with action steps. He is a member of FINRA/SIPC, a registered broker-dealer and investment adviser.