August 11, 2024

by Stephen Stofka

This week’s letter is about bonds. Many older investors have bond funds in their portfolio because they are told that it adds safety to a portfolio. Like ballast in a ship, bonds reduce volatility when a storm approaches and the water gets choppy. As the Federal Reserve raised rates in the past two years, the bonds in our portfolios acted as a dead weight, producing net negative returns. Why are bond prices so sensitive to changes in interest rates? Why are bonds so weird?

An individual bond is a claim on someone’s debt. A bond fund or ETF is a mixture of individual bonds of various terms to maturity, the length of time to the date when the debt claim ends. These maturities are grouped into three categories: short, medium and long-term. Short-term refers to bonds that mature in less than two years. Bonds with terms of two to ten years are considered intermediate-term and longer than ten years is categorized as long-term.

The length of term is correlated with a bond fund’s sensitivity to interest rate changes. Short-term bonds pay the lowest amount of interest but are the least sensitive to interest rate changes. According to Portfolio Visualizer’s back tester tool, a composite of short-term bonds had an annual return of -0.82% since January 2020. A bond ETF with an intermediate term returned -2.79% annually. Long-term bonds were particularly affected by the rise in interest rates, returning -6.87% annually. I will leave the details in the footnotes.

Why does the price of a debt instrument like a bond react to changes in interest rates? Opportunity cost. If I buy a $1000 mortgage bond paying $50 annually, and shortly after, new mortgage bonds are paying $60 a year, I will have to sell my bond to another buyer for a discount, given the fact that both bonds have the same risk profile and maturity. The income stream on the bond I own cannot compete with the higher income stream from new bonds at the same price.

A bond’s duration is a measure of its price sensitivity to a 1% change in interest rates and is published by financial news outlets like Morningstar, where readers can check the duration of a bond fund or ETF they hold. That number indicates the percentage change in price for each 1% change in interest rates. For readers who want to go deeper into this, Rich Falk-Wallace posted up on X a Bond Math table of forecasted price changes in response to various changes in interest rates.

Using our sailing analogy, the term of a bond is like the height of a mast on a sailboat. A longer-term bond, like a taller mast with more sail exposed to the wind, will get us somewhere faster in calm winds (or pay a higher dividend), but leave us dangerously exposed when wind speed increases. The table mentioned above shows that a 30-year Treasury bond can have suffer a 30% loss in price for a 3% rise in interest rates, a price response of ten times the change in interest rates. Yikes! The leverage effect is even greater when interest rates fall. The table indicates a price rise of 72% for a 30-year Treasury bond when interest rates fall by 3%, an effect that is 24 times the change in rates!

Relative to stocks, price changes in bonds are tame. In 2022, a broad composite of bonds like Vanguard’s BND ETF experienced a 10% decrease in price, and it was historic. A similar decrease in the price of the SP500 stock index is a “correction,” a cause for concern. A 50% decrease in stock prices is historic. The stock market is like riding on a dirt road in a 4×4 jeep. The bond market is like riding in a car on a paved road. We react strongly to any rough patches or potholes.

There is a positive aspect. Depending on your financial situation, it may be prudent for an investor to convert a regular IRA invested in bonds to a Roth IRA. The investor will have to pay income taxes on the capital gains, but those gains have been reduced in the past two years. Once converted to a Roth, any subsequent gains will be tax-free. A Roth IRA has no required annual withdrawal, so an investor has more control over their funds in retirement. Some investors may have what are called unrealized losses in a taxable account that holds bonds, and these could be used to offset gains this year if sold. These are options that some readers may consider and discuss with their financial or tax advisor.

For several decades, interest rates on savings were so low that investors used index funds as a way to earn a higher return on their savings. In the years following the financial crisis, the lack of inflation was more a risk than inflation. In such an environment, investors may have not fully appreciated the difference in risk between bond funds and money market funds. In the decade following the financial crisis, 2008 through 2017, a broad composite of bonds earned 3% or more when savings accounts were paying almost 0% and money market accounts were barely paying 1%. In the last seven years, the return on bond funds has been 1% or so. Investors who piled into longer-term bonds with higher returns were hit hard when the Fed raised interest rates in 2022 and 2023.

A bond’s term to maturity indicates price sensitivity to interest rate changes. An investor’s term to retirement indicates portfolio sensitivity to market conditions and mistakes in judgment. Someone in their thirties can be more aggressive and recover from judgment errors more ably than someone in their sixties. That reality underlies the conventional advice that people should devote a greater portion of their portfolio to bonds when they are older. However, bond investors may have felt like unlucky victims when bond market prices sank in 2022-23. Dramatic market shifts reinforce the rewards of diversification. At the heart of the math on bond duration and risk diversification is an aphorism we learned as kids: don’t put all your eggs in one basket.

//////////////////////

Photo by Christophe Ferron on Unsplash

Bond Notes: Short-term bond ETF: Vanguard’s BSV. Intermediate-term: BIV; long-term: BLV.

Keywords: investing, bonds