Why it’s been a bad year for the bond market

For investors, it has been a trying year: Both stocks and bonds have been down at the same time, which is not common.

It is quite rare for bonds to be down in any material way during periods of stock market declines. To put this into perspective, the current level of declines in portfolios holding both stocks and bonds is among the worst in history.

Bonds are held in portfolios primarily because they help to soften the sharper edges of stock market volatility. Most of the time when stocks are down, bonds are up (or only experience relatively modest declines).

In the past 46 years, over a calendar year, bonds produced a positive return 90% of the time (42 out of the 46 years). Prior to this year, the next largest 12-month decline (i.e., including intra-year declines) was in 1980 when bonds (as measured by the Bloomberg Aggregate Bond Index) went down by 9%. The market ended that calendar year up by 3%.

So why are bonds acting this way and what are their prospects going forward?

The driver of these declines has been the swift rise in interest rates. When interest rates go up, the value of underlying bonds goes down. Bonds are simple on the surface, but complex in the real world.

For many, this might not make sense. If interest rates are going up, then am I not making more in interest income? The problem comes when you try to sell a bond earning 1%; it will not appear very attractive to a potential buyer when they know they can get 4% in a similar bond issue.

At the risk of becoming overly technical, I’ll provide an illustration to show what I mean: On Jan. 1, 2021, let’s imagine that you bought a one-year bond the day that it was first issued for $1,000 and it earns 1%. After one year you will have earned $10 in interest income (1% of $1,000) and you will get your $1,000 back.

But what happens if you need cash and decide to sell the bond seven months after buying it, but rates for similar bonds have gone up to 4% during those seven months?

If you try to sell the bond for what you paid for it ($1,000) no one would buy it. Think about it: if you were a buyer in the market and had $1,000 and you could choose between two investments of equal risk characteristics and one earned $10 and the other $40, why would you pick the lower one? No one would choose 1% when they could get 4% on the same initial investment.

What you then do is lower your price in such a way that the buyer would earn 4% or $40.

In this case, you would have to sell the bond for $982.97. This is a simplification of some extremely complicated calculations, but the buyer is indifferent to spending $1,000 on a new issue bond that earns 4%, or $982.97 on a bond that earns just 1%. Both end up earning 4%.

For the seller, that would represent a 1.7% loss. And this is what is happening across the board in the bond markets. Interest rates are going up and investors who currently own bonds are seeing losses – though only on paper.

And this is another important concept: If the original investor just holds that same bond until it matures, he or she would never experience a loss. They would earn their $10 and get their $1,000 back, which they can then reinvest at 4%.

For most investors, bonds are held in mutual funds. These are highly diversified funds typically comprised of thousands of individual bonds with a range of maturities (that is, they come due on many different dates). Some funds are comprised of U.S. Government Treasuries (considered to be among the safest investments in the world) and others are of high-quality U.S. corporate issues.

It is crucial to work only with trusted fund managers because while the bond market is huge (many times larger than the U.S. stock market), it is very opaque.

As a result, if you do not follow it minute by minute and know who owns what bond where for what price, it is very easy to buy at less-than-optimal prices.

Or to put it another way, unless you are a professional bond trader, it is very easy to make mistakes or get taken advantage of.

My advice is to only hold the highest quality bond issues that are shorter on the maturity range: typically, from less than one year to rarely more than seven years. Bonds with shorter maturities are less susceptible to the negative impact of rising interest rates because they are coming due faster and being reinvested at the now higher rates.

I also advise investors against “reaching” for yield (taking extra risk to eke out a bit more return) or investing in “high yield” bonds (aka “junk bonds”). Bonds are in the portfolio to reduce overall risk and dampen volatility. They are not intended to amplify returns over the long run.

The past nine months have been rough on bonds, and they have not been as effective as expected.

But the truth is that bonds represent a better value now and have a higher expected return than they have in many years.