Bonds, a haven for the cautious, are getting torched
Bonds are supposed to be the safe part of any nest egg, but they’re getting brutalised.
High-quality US bonds have lost more than 10 per cent so far this year, as of Monday, on pace for one of their worst years in history. The investors feeling it the most are the very ones who invest conservatively, favouring bonds instead of stocks in hopes of securing historically steady returns.
To put the misery in context: This year’s loss so far is more than three times as big as the worst year on records going back to 1976. The previous worst performance was a 2.9 per cent loss in 1994, according to a widely followed index that measures investment-grade bonds.
So not only is losing money on bonds a surprise for many investors, the amount of this year’s carnage is also a shock.
“There’s kind of this false perception of: Bonds are bulletproof and can’t lose money,” said Matthew Benson, owner of Sonmore Financial in Chandler, Arizona.
This year’s losses for bonds are a result of high inflation sweeping the world and the Federal Reserve’s response to it. Inflation, in general, is anathema to bond investors because it weakens the buying power of the fixed payments bonds will make in the future.
The Fed’s main weapon to bring down inflation is raising interest rates. But this causes newly issued bonds to pay higher yields, making older bonds sitting in investors’ portfolios suddenly look less valuable than before. That, in turn, makes prices fall for those older bonds.
Any investor who bought a bond and simply holds on until it matures will still get the full value of their principal back, along with all promised interest payments, assuming no defaults. But they’d be making more if they had that same principal money invested in a newer, higher-yielding bond.
“It is a challenge and it is a problem, and it’s something we’re reviewing with our clients,” said Charles Sachs, chief investment officer at Kaufman Rossin Wealth. “The optics aren’t good. The bond gets priced every day, and if it matures in two years or three years, you will get paid out, but nobody wants to see losses along the way.”
Bond prices have often fallen in the past, including as recently as 2018. But even then, bonds usually paid enough interest to make up for their price drop. In 2018, for example, prices for high-quality bonds fell 2.9 per cent. But after counting the income they paid, investors eked out a positive total return of 0.01 per cent.
Coming into 2022, though, bonds were paying little. The 10-year Treasury’s yield was at 1.51 per cent, for example, versus its average of 2.94 per cent over the last 20 years. That gave investors less cushion for drops in price.
Some financial advisers are responding by shepherding their wealthier clients into complex, alternative products like private mortgages or funds that use hedge fund-like strategies.
Many professional investors and advisers say investors nevertheless shouldn’t give up on bonds, even with their losses, because they remain a better bet than stocks to fill the role of ballast in a portfolio. An old rule of thumb says a portfolio should be 60 per cent invested in stocks and 40 per cent in bonds, with the stock portion ramping up or down, depending on an investor’s willingness to take risk.
Bonds have held up better this year than the stock market, with the S&P 500 down 16.3 per cent for 2022 through to Monday.
“Nobody put bonds in their portfolio because they thought it would be the best performer,” Benson said. “You’re not going to get the same four per cent to sevenper cent total return out of a bond fund that maybe you would have over the last 25 to 30 years. But the reason somebody moved to bonds in the first place is, they wanted less volatility.”
Part of that is because bonds produce steady income, something needed by retirees and other investors. And bonds bought today are offering more income because of the rise in interest rates. The yield on the 10-year Treasury has roughly doubled so far in 2022, recently jumping above three per cent to its highest level since 2018.
Bonds can still lose more money, as this year painfully demonstrates.