BONDS ARE ON PACE to have their worst year on record. To be sure, once interest rates stop rising—perhaps early next year—they may win back their place as a worthwhile investment for retired investors. But right now, that feels like wishful thinking.
As the Federal Reserve has hastily raised short-term interest rates in big steps to fight inflation, bond prices have fallen down the cellar stairs. Bloomberg’s broad U.S. aggregate bond index is down 16% in 2022. It’s the worst year for U.S. bonds since reliable recordkeeping began in 1926.
Bond prices fall when interest rates rise because bonds issued earlier—which pay lower rates—get discounted until their return equals the currently available yield on new bonds. No less an authority than Vanguard Group declared the six months through June 2022 the worst half-year for bonds “since either before the Civil War or George Washington was president.” If you’re wondering, the Civil War began in 1861 and Washington’s second term as president ended in 1797.
Bonds are supposed to provide a counterweight to stocks and act as a stabilizing force during bear markets. That hasn’t happened this year. Nothing’s worked.
Now for the better news: Bonds could rise from the ashes and make a valuable contribution once again to a retiree’s portfolio. The 10-year Treasury note yielded more than 4.2% in late October, its highest rate in 15 years, though that remains below the current U.S. annual inflation rate of 8.2%.
Still, higher bond yields could signal the end of TINA—the mantra that there’s no alternative to stocks. Since 2010, many investors who wanted income turned to dividend-paying stocks because bond yields were hovering near zero. Now, the yields on super-safe Treasurys can compete with utility stocks and easily outpace the dividend yield on most other shares. The S&P 500’s dividend yield is currently 1.7%.
I was taught there were three main asset classes: stocks, bonds and cash. The one to avoid when investing for retirement was cash because its returns were too scant. I broke this commandment when I retired in 2020. I sold bonds and stocked up on cash—not rustling paper cash, but certificates of deposit and other investments that promised stability of principal.
At the time, the 10-year Treasury yielded less than 1%, so I wasn’t missing out on income. Interest rates would have to rise someday, I reasoned, so bonds had nowhere to go but down. In the meantime, most of my cash accounts—which also yielded only 1% or 2%—were at least insured against loss by the Federal Deposit Insurance Corporation.
But now my cash is losing lots of ground to inflation. “Inflation will likely linger at an abnormal level for at least another season, which will keep the markets on edge,” Vanguard concluded in its third-quarter bond analysis.
What to do? At some point, I should switch from cash back to investment-grade bonds, but perhaps not just yet. The Federal Reserve is expected to continue raising short-term interest rates for a while longer, and that could send bond prices down again. There’s talk that the Fed will slow its campaign of interest rate increases next year, at which point bonds may stabilize.
At that juncture, bonds could win back their place in retirees’ portfolios. We could bank on bonds’ predictable stream of income, plus bond prices are historically less volatile than stocks. More income with less risk sounds promising.
What if inflation stays stubbornly high? That could dampen bonds’ comeback. Still, it’s worth remembering that investments often perform their best after they’ve been through hell—and when they’re most despised by investors.
Sounds like a lot of trying to time the bond market. And the bond market has been as volatile as the stock market.
An income alternative can be one based on academia and a long historical track record.
Research shows that a 50/50 portfolio representative of the Large and Small cap value universes / indexes has sustained between a “3.5% – 7%” inflation adj annual withdrawal rate ( “sale of shares”, dividends reinvested ), accompanied by terminal portfolio growth, over seventy one rolling 20 year periods ( and even rolling 30 year periods ) since 1931 ( Charts 2 and 3 https://tinyurl.com/yckmev96 ). An investor can own the small and large value stock universe through investment in low expense ETFs.
I have been out of bonds for several years, and in a stable value fund.
Yields on the bonds finally surpassed the SV fund by a full point a couple months ago, so I sold half the stable value fund and bought a Treasury Bond fund. It was a process based decision, and hasn’t gone so well so far, but that’s ok, I’ll be holding those for a long time. Still, I wouldn’t mind a nice little bond rally to help me break even for the year!
Why are you holding cash that you don’t need in the next year instead of TIPS bonds that keep up with inflation? You can see the current rates at https://www.wsj.com/market-data/bonds/tips?mod=md_bond_view_tips_full
If you buy the bond maturing in Jan 2024 and hold to maturity you’ll earn 2% above inflation.
Why is practically everyone so certain that interest rates will stop rising and go back down in the coming two-three years?
They might do that – I know nothing – but could easily keep rising higher and longer than anyone expects. Among other factors, rising national debt levels that approach annual GDP are not encouraging.
On the threshold of retirement, I’m just glad to have taken advantage of 2021 to shift asset allocation to 45/55 stocks/2-year bonds. It’s come down further the old fashioned way, and I’m just letting that ride.
I make no assumptions either way. Maybe rates will plunge and stocks roar again before my check-out date, but it could also pass that we’re entering a replay of the 1970s-early ’80s.
We’ve nearly left the bond club, not for stocks. Our target stock allocation has stayed steady, but for the past year or so most of our fixed income allocation has been in cash, and most of that in a 401k stable value fund. Expect the small amount we’ve continued to hold in bonds will now also see some light.
I just posted the above comment to John Yeigh’s TINA article but it seems appropriate to do so here too. (I returned to finish reading John’s this morning after a busy few days before catching up on others.)
I got spooked late last year when I ran across a blog where a guy showed how much a bond fund like Vanguard’s BND ETF would lose when interest rates started rising, and it was a real eye-opener. I feel fortunate that we had access to my wife’s TSP “G” Fund, a stable value fund that pays 5- to 10- year-like returns without the attendant interest rate risk that has absolutely clobbered most bonds and bond funds this year. I guess in the realm of 401(k) vs IRA debates, you have to chalk one up for the 401(k) in this round, as most of our IRA’s don’t have access to such magic as this. So yeah, I guess even diversification across different account types can be a good thing, as having access to such an account does help me sleep a little better at night.
Ditto
For the last several years as I approach retirement I kept on looking into various types of bond investments but could never justify pulling the trigger while the yields were so low, and now glad I waited. The only investment adjustments we’ve made during this odd year are cash-and-income related. Our last managed fund was traded for a dividend-income index fund. Cash went into I-bonds. And after we sold one of our vacant lots the proceeds along with excess cash from our checking account opened a high-yield online bank savings account. My spouse was reluctant about moving money from our local bank to some online account until I pointed out that the additional interest earned in only 6 months will pay for two high-efficiency windows or a real nice front entrance door for our long-planned house remodel.
By keeping rates so low for so long the Federal Reserve created a bond bubble that popped in 2022. As you mention in closing when a sector has been battered it sometimes gets attractive. You also worry about rising rates and inflation. For me that has lead me to buying individual TIPS going out 5 years. If the CPI keeps rising then TIPS keep paying more. If the Federal Reserve keeps raising rates then I keep buying the same holdings and hold to maturity. I will own underlying Treasuries. Holding them in a Roth I don’t worry about phantom taxation. Of course if the CPI drops then I would be better off holding short term Treasuries.
Greg, thanks for this. Strange times, indeed. I’ve basically reversed my allocations of bonds and cash, with cash now being the bigger component. Just wish I’d done it earlier like you did.
Greg, from a long time retiree perspective, I look at the situation a bit differently. My investments in utilities and municipal bond mutual funds are for income stream at some point – for decades and currently dividends and interest are reinvested.
The prices of both are down for sure, but that means as dividends have grown modestly and with interest payments rising, I gain more shares.
Other than reinvestment I haven’t purchased new utility shares in decades so my yield on my main utility holding is now about 5.4%. My municipal bond fund is yielding 4.16% tax free.
Now for a retiree needing to draw from holdings as income it’s a different story. I wanted a steady source of income someday and I hate paying taxes.
Did I do the right thing? I’m not sure, but it feels pretty good right now.
These are not your father’s utilities these days. They are heavily politicized, and far down the road of replacing a grid that was the wonder of the world with one that is unreliable and far more costly.
If the dividend yield is up only because the price is down then I don’t know that I would consider that a good thing.
Me neither unless you were accumulating for the long term. As I said I purchased the stock decades ago at about $20 less a share than it is now.
Dick, congratulations on your choices. Utilities were a good place to earn a solid yield in stocks when bond rates fell to near-zero. And munis provide the extra kick of tax avoidance, which raises their effective return nicely. My main complaint was with Treasurys, which had paid little more than cash for a decade and yet carried interest rate risk—as led to significant losses this year. With the yield now back to 4%, bonds are competitive again.