Sid Roy & Sanjib Saha
16 July 2024
If you’re questioning the value of bonds after a challenging 2022, you’re not alone.
Many investors have learned the importance of balancing their investments between stocks and bonds. Stocks and bonds are expected to behave differently—when one falls, the other should stay put or even rise—creating a more stable portfolio overall. Yet, we’ve recently experienced a period that challenges these assumptions and shakes up our investment approach. Both stocks and bonds ended 2022 with significant losses. This wasn’t supposed to happen, right? How can bonds lose so much value when stocks are also struggling? Did they miss the memo?
The short answer is: No, we did.
Investing is simple, but not overly so when it comes to adding bonds to your portfolio. For stocks, most of us are fine with passive investments in broadly diversified, market-cap-weighted index funds. However, bonds are a different beast altogether. There are several nuances to consider, especially if you’ve chosen a simple aggregate total bond index fund.
Intrigued? Let’s review some basics of bond investments.
Bonds offer fixed, nearly guaranteed income and, more importantly, they are designed to preserve invested capital. This security and predictability of return come at the cost of lower total returns compared to riskier stock investments, and that’s acceptable. A diversified portfolio should include a riskier portion for potential higher growth and a safer portion for predictability and stability. Bonds serve as the safer part of the portfolio, but they are not without risk. Understanding the risks associated with bond investments is crucial. Equally important is understanding whether your specific bond investment, such as a passive aggregate total bond fund, is exposed to those risks and to what extent.
Firstly, consider credit risk—will the issuers of the bonds be able to pay interest and return principal on time? Secondly, there’s interest rate risk—will bonds lose market value if interest rates change? Thirdly, inflation risk—will bonds keep up with inflation, especially during unexpected inflation spikes? Investors need ways to control their exposure to these risks. Unfortunately, typical passive aggregate total bond funds often fail to provide such control, leading to unpleasant surprises like those in 2022. This is because passive investors in a total bond index fund were unknowingly exposed to the risks that pushed the Bond market down that year.
Consider inflation risk—an insidious threat to bond investors. Even short periods of runaway inflation can permanently erode purchasing power and destroy the real value of bonds. Unfortunately, many US investors have not taken inflation seriously, thanks to decades of low inflation and the Federal Reserve’s commitment to price stability. But recent years have shown that inflation risk is real.
To add insult to injury, higher-than-expected inflation can also depress the market value of existing bonds. Why? Because prospective bond investors will demand higher yields to compensate for high inflation, causing bond prices to drop (bond prices move inversely to their yields).
How can you mitigate inflation risk? The easiest and most effective method is to include inflation-protected bonds as a substantial part of your bond investments. A typical total bond index fund has little to no exposure to inflation-protected bonds, leaving investors fully exposed to unexpected inflation.
Even if we assume inflation will remain low indefinitely moving forward, and that the recent inflationary pressure was solely due to the one-off pandemic and supply chain disruptions, there’s another risk to worry about: interest rate risk. Specifically, the risk that rising interest rates will push down the market value of existing fixed-coupon bonds to match their yield to that of newly issued bonds.
There are two ways to reduce exposure to rising interest rates: invest in adjustable-rate bonds whose coupon rates rise with an interest rate index, or invest exclusively in short-term bonds. Longer maturity bonds are much more sensitive to interest rate changes.
Once again, a typical total bond index fund has little exposure, if at all, to adjustable-rate (floating-rate) bonds. Furthermore, passive investors have no control over the average maturity of bonds in the fund, as its composition depends on the total outstanding debt in the market. For reference, today’s total bond market index can lose about 6% or more of its value for each percentage point increase in interest rates. To refresh our memory, the Federal Reserved hiked the interest rate by over five percent within a span of a few months, causing havoc to market prices of existing bonds.
Thankfully, investors in a total bond index fund are somewhat protected in terms of the creditworthiness of debtors, as the majority of the outstanding bonds are from US government and government agencies, which enjoy top-notch credit ratings with practically zero default risk. Nevertheless, the unchecked risks of inflation and rising interest rates can leave these investors in a precarious state. The year 2022 proved to be a perfect storm where both of these risks materialized, erasing a significant portion of the market value of total bond index funds.
Let’s reconstruct the market environment post-pandemic. Interest rates were so low that the only direction they could go was up. Supply chain issues limited consumer goods, driving prices higher. At that time, the last thing bond investors needed was higher exposure to risks of interest rate hikes and inflationary pressure. Unfortunately, investors in total bond index funds had no choice. In fairness, passive investors should not have to focus on current market conditions or the economic environment. The truth is that passive bond investors do not have this luxury.
What might have been a safer approach for bond investors at that time? In other words, what would a semi-passive bond investor do? The answer is twofold. First, overweight inflation-protected bonds while expected future inflation remains low. Second, reduce the average maturity (or more technically, the average duration) of bond holdings. Those who did so were able to avoid disaster. However, those who were complacent with their passive total bond index funds were negatively affected by subsequent persistent inflation and rapid interest rate hikes. As a result, 2022 was one of those atypical years when both total stock index fund and total bond index fund ended in the red.
Moral of the story
Instead of relying solely on a total bond index fund, it pays to be aware of the heightened risks and opportunities due to current market conditions and adjust bond investments accordingly, perhaps through narrower bond funds.
Avoid sacrificing credit quality for slightly higher returns. Investors with a higher risk appetite may consider increasing exposure to stocks rather than compromising on the credit quality of their bond investments.
Inflation risk is real and has immediate and long-term effects on bond investments. Inflation-adjusted bonds mitigate this risk.
When interest rates are high, longer maturity bonds are attractive. Conversely, short-term bonds are safer when interest rates are low. What about medium interest rates? A barbell strategy – with half in short-term and half in longer-term bond funds – might come handy.