Last month, a longtime friend told me a story about a 78-year-old acquaintance of his who had lost a very significant amount of money last year (2022). She was taken by surprise because she had invested nearly all her money in government bonds or bond funds and anticipated that her investment would be “safe.” Safe, in her mind, meant that her portfolio of bonds would not ever go down. Yet she watched as the value of her portfolio went down month after month. Like so many investors, she had been told “stocks are risky, bonds are safe.” Also, like many investors, she looked at her bond portfolio much like a savings account: put money in, collect some interest along the way, and either sell the bonds or cash them upon maturity for full face value; neither risking nor losing anything at all.
The value of bonds fluctuates inversely to the prevailing interest rate. As interest rates go up, bonds fall in value, and vice-versa. Think about it for a moment. If you own a $1,000 bond that pays 4% each year until it matures, as the holder of the bond you will collect $40 interest per year ($1,000 times 4%). But suppose prevailing market rates are now 5%. If you try to sell your bond the buyer will likely say, “I can invest in a new bond and get 5% and since I am only going to get $40 a year from your bond, I will not be willing to pay full value for your bond. Therefore, the current market value of your bond has gone down. That’s an oversimplification, but my aim here is to explain one of the big reasons bonds fluctuate in value, often as much, or more, than stocks.
Many people think that the only rates that matter are those imposed by the Federal Reserve. We all know that the Fed has been raising rates in its attempt to stem inflation. However, the Fed only controls short-term rates. Rates on longer-term notes and bonds are controlled by the bond market, and, like stocks, are bid up and down based on how the bond market perceives the risk of holding
Do you get the impression that bonds need to be managed? I hope so, because they do.
the bonds to maturity, among other things. (By the way, in 2020, rates briefly fell into negative territory.) One way to mitigate the risk of bonds fluctuating in value is to buy an individual bond and simply hold it to maturity. You then collect the face value as long as the issuer has the funds to redeem them. You must be willing to see the value fluctuate on your monthly or quarterly statement. It’s also a good idea to spread the maturity dates over several periods so as to avoid having all your bonds coming due at one time. We see people making the mistake of investing their entire portfolio into one maturity date because it’s the highest yielding at the time they are investing. Reinvestment is then subject to the prevailing rate at that time. A better approach might be to ladder maturities so that similar amounts come due at various intervals in the future.
Do you get the impression that bonds need to be managed? I hope so, because they do.
Most investors (and retirement funds) obtain professional management of bonds by buying into a bond fund. Bond funds (which are essentially a managed portfolio of bonds with various maturities and quality) don’t have a maturity date. Therefore, a redemption value is not locked in, as it can be with individual bonds. The manager of the fund keeps buying and selling bonds in an attempt to earn a total return (interest paid plus or minus gain/loss on the sale). The fund will have a calculated “average maturity date,” but there is no promise of value at that date. I have a feeling that my friend’s acquaintance—the one mentioned at the beginning of this article—held bond funds and watched the value of her portfolio go down as interest rates went up last year. Since the total return on the aggregate bond market has been negative for three years, she may have a long recovery period.
Many advisors will say that the best way to mitigate investment risk is to have a portfolio that is diversified between stocks and bonds. “Get the asset allocation right, then buy, hold, and rebalance; and all will be okay,” they will say. That did not work out so well last year. A portfolio invested 40% in the Barclays U.S. Aggregate Bond index and 60% in the S&P 500 would have been down by almost 16% because both stocks and bonds went down. At this writing in the beginning of April, that 60/40 mixture has recovered about 6% since the end of the year. Both indices are under extreme pressure. This is probably not a good time for asset allocation strategies to produce positive return.
So, what’s a person to do? There are really three factors that contribute to total return: 1) asset allocation, 2) security selection, and 3) timing. If asset allocation is off the table, then more weight must be put on security selection and timing. These two should be controlled by your belief about where the economy is headed and what will perform well in that economic environment. You might be wrong in your belief and need to adjust course as time goes on. The big questions we wrestle with are: Will the Fed need to keep raising rates or will they be able to bring in a soft landing? Will we suffer a recession this year? Will inflation continue? What about employment and wages? One thing is certain—the answers to these questions are not knowable with certainty. That means one must pay attention as they unfold and be willing to adjust.
Scott Neal, CPA, CFP is the president of D. Scott Neal, Inc. with offices in Lexington and Louisville and now serving clients in 27 states. He can be reached at 1-800-344-9098 or by email to scott@dsneal.com