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BACK IN THE 1980s, Michael Milken earned notoriety as “the junk bond king.” With his swagger—and his toupee—Milken was an outsized personality in a normally staid industry. But that was four decades ago. It may have been the last time that bonds were truly interesting.
On most days, bonds are about as dull a topic in finance as you can find. But here’s the challenge for investors: While bonds might be boring, they’re important—and they can be tricky.
Consider the Vanguard Total Bond Market Index Fund (symbol: VBTLX). As its name suggests, it’s designed to offer one-stop shopping for bond investors. For that reason, total market funds like this are one of the three pillars of the vaunted three-fund portfolio. They’re intended to be an easy set-it-and-forget-it solution for investors looking to add bonds to their portfolio. But the funds are far from perfect.
Just look at 2022. When the stock market was down—and thus when investors would have benefited most from the relative safety of bonds—total bond market funds lost about 13%. It’s too simplistic, though, to criticize these funds solely because of one year’s performance. Instead, it’s worth looking under the hood to understand why they struggled in 2022. These were the two key drivers:
Duration. The biggest driver of bond prices is a metric known as duration. In simple terms, it’s a measure of how long it would take a bond investor to get back his or her money.
Suppose you own a bond that matures exactly one year from today. At first glance, you might conclude that the duration of this bond would be one year—because that’s when you’ll get your money back. But because most bonds make periodic interest payments prior to maturity, you’ll end up receiving your original investment back a bit before the one-year mark. As a result, the duration of this bond will be a little less than one year.
That might seem straightforward, but how does duration impact a bond’s performance? To understand this, suppose you wanted to buy a bond today. You have lots of choices. The first option might be a recently issued Treasury bond that offers a 5.5% coupon (or interest) rate. Alternatively, you could buy a two-year Treasury that was issued last year.
In both cases, the bonds will mature one year from today. But because interest rates were lower last year than they are today, the coupon rate on the older bond will be just 4%. That will cause the older bond to be worth less. Why? Suppose the new 5.5% bond is selling for $1,000, which is the standard price for new bonds. If that’s the case, you certainly wouldn’t pay the same $1,000 for the older 4% bond. You might still be willing to buy it, but only at a lower price.
What would be the right price for this older bond? You’d want enough of a discount on this older bond to make up for its lower 4% coupon rate, because that 4% is 1.5 percentage points below the 5.5% rate available on a new bond. The discount you’d want would be $15—because $15 is 1.5% of $1,000. Result? You should only be willing to buy a 4% bond today if you can get it for around $985—in other words, for $15 less than a new $1,000 bond.
A key point here is that bonds always mature at their “par value.” Even if you’re able to buy a bond for $985, you’d still receive the $1,000 when it matures next year. Thus, if you were to buy the older 4% bond for $985, you’d make money over the next year in two ways. First, you’d receive the 4% interest payments. Second, between now and maturity, you’d pick up another $15. So, in total, you’d make 5.5% on this bond—the same as you’d be able to earn on a newly issued 5.5% bond.
That’s the basic concept behind duration, and it explains why older bonds decline in value when interest rates on new bonds rise. And that’s precisely what happened last year. In 2022, the Federal Reserve raised short-term interest rates 4.25 percentage points over the course of the year. This negatively impacted the value of older bonds.
There’s one more element of duration to understand, and this is a crucial point for bond investors: The greater a bond’s duration, the greater the risk when interest rates rise. To see why, let’s look at another example. Suppose you want to buy a bond that matures in two years. You could buy a newly issued two-year bond with a coupon around 5.5%. Or you could buy a three-year bond issued last year. Again, because rates were lower last year, that older bond will only pay about 4%. But both will mature at the same time, two years from today. Now, how much would you pay for this older bond?
Following the same logic as above, you might be willing to purchase the 4% bond, but you’d want a discount. How much of a discount? In the example above, we calculated a $15 discount, because that’s what would be required to make up for the 1.5 percentage point gap in coupon payments over one year.
But in this case, if there are two years to maturity instead of one, the discount will need to be greater. That’s because buyers will now want to be compensated for two years of lower interest payments. In round numbers, the discount on this two-year bond would need to be around twice the discount required on the one-year bond—$30 instead of $15. The key lesson: Duration is a critical driver of bond prices. And the longer the duration, the greater the price risk on a bond.
Composition. The bond market is very diverse. The U.S. Treasury, of course, issues bonds. So do states, as well as cities and towns. And corporations of nearly every stripe also issue bonds. At first glance, you might think that these differences would be an important factor in the performance of bonds. To be sure, they’re a factor, but not nearly as significant as you might guess.
Consider how a set of popular bond funds performed in the face of 2022’s steeply rising interest rates. Vanguard’s intermediate-term corporate bond fund (VCIT) lost about 14%, while its intermediate-term Treasury bond fund (VGIT) fell around 11%. Meanwhile, its short-term corporate bond fund (VCSH) lost about 6%, while its short-term Treasury fund (VGSH) slid some 4%.
What can you conclude from this? I see two key points: First, in rough markets, Treasury bonds tend to hold their value better than corporate bonds. That makes sense since—despite Washington’s political dysfunction—the U.S. Treasury is still a safer bet than even the most stable corporation. That explains some of the performance difference between the two categories.
That difference is dwarfed, however, by the performance difference between short- and intermediate-term bonds. Short-term bonds, with their shorter durations, held up much better in 2022 than their intermediate-term counterparts. As you can see, even short-term corporate bonds held up better than intermediate-term Treasury bonds. Long-term Treasury bonds fared even worse, with many losing nearly 30% last year.
This is why, in structuring your portfolio, I would lean heavily on short-term bonds. Since interest rates are unpredictable, I see that as the best route to preserving value. And that’s why total bond market funds, despite their reputation for simplicity, aren’t—in my view—a great solution. The problem, as you can probably guess by now, is that the duration of these funds is quite long and, indeed, similar to the intermediate-term funds referenced above. They might be appropriate for part of your bond allocation, but I’d make it just a small slice.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.
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I Bought etf TLT. Long term bonds (treasures) Just going to wait till feds rate comes down to cash in. could be awhile, but it will happen.
But isn’t it true that with longer duration bonds (both individual and funds) most of the return is due to interest, and interest on interest? As the duration increases doesn’t the price fluctuation effect diminish relative to the return generated by interest (and reinvested interest)?
As always, this was an excellent article, Adam. Thank you. However, I think you left out an important point. While bonds certainly drop in price when interest rates rise, as they have been doing for the the last 2.5 years or so, the reverse is also true. When interest rates fall, bond prices rise.
Investors who invested in bonds in 1980 lived through an almost continuous decline in interest rates for the next 40 years. There were certainly some periods of time when interest rates increased, but the long term direction for interest rates was down. The result was that investors who held bonds during this period generally earned more than the coupon. And the investors who earned the most were those who owned long term bonds because they have long durations.
Had a few long term bond holdings in Unit Investment Trusts bought during the 80’s go-go years. Very good coupon rates; alas, all the underlying bonds in the UIT were called when interest rates dropped. Then had to reinvest at prevailing rates.
Will all due respect, I strongly disagree, for reasons you already touched upon. While intermediate term bond funds do have a higher duration, the issue you’re describing is overall portfolio duration, not bond fund duration. One can simply combine an intermediate term bond fund with a money market fund in their portfolio, and depending on the ratio between these two funds, achieve any duration they desire. In a taxable account, this method has the significant benefit of never needing to sell your entire bond fund just to change the overall portfolio duration. By contrast, if you have a short-term bond fund, you’re mostly stuck with that duration, unless you also hold an intermediate bond and money market fund; a total of three funds. This means the portfolio is needlessly complex, because with just two funds, you could have accomplished the same duration as any combination of the three funds.
My bond allocation is 30% ST Treasury fund, 70% BND. I am convinced: stocks for growth and ST bonds for stability. What do I do with BND holdings? Move now or let them recover and move to ST Treasury? I’m a long term investor, not chasing yields, and honestly want to change asset allocation approach. I’m retired.
It’s a tough decision. But here’s something to keep in mind: A diversified bond portfolio is a different animal from a diversified stock portfolio. Yes, bonds should eventually mature at their par value. But you shouldn’t expect bonds to rebound from a sharp decline in the same way that stocks should. Rising corporate earnings will eventually drive share prices higher. There’s no such mechanism with bonds. With bonds, the best guide to future returns is the yield to maturity and, in the case of Vanguard Total Bond Market, that’s currently 4.9%:
https://investor.vanguard.com/investment-products/etfs/profile/bnd
This is the finest article on bonds that I have read. The bond market can often be more confusing than the stock market. Thank you Adam.
Great article. Thank you. I very recently retired and immediately became more comfortable with using a bond ladder to match my assets with my anticipated liabilities. I am 60 and currently have a chunk of my fixed income as a bond ladder to get me to Social Security at 70. I don’t want to go through another 2022 and am no longer a big fan of total bond index funds. Thanks again.
To clarify: if I were still accumulating and had a decade or more to save, I’d still be in a total bond index fund, I think. Right now I’d be buying the higher interest bonds which will pay off over the duration of the fund (as I think I understand it!)
Excellent article, Adam. Thanks as always for another straighforward and understandable explanation.
With Vanguard’s VMRXX money market fund currently yielding 5.30%, what are the pros and cons of it vs. VGSH, Vanguard’s short term treasury ETF, currently yielding 5.09%?
I think if interest rates start to fall, then the yield advantage would flip to VGSH. Money market rates would drop quickly, but you could be reasonably sure to earn 5%+ over the next year in VGSH.
Thanks for this. My bond holdings are a little in VCLT, more in VCIT and most in VCSH. Earlier this year I sold all my holdings in VCSH to invest in SWVXX. At some point I’d like to cycle back into VCSH. I think people do a disservice to themselves by investing in a broad bond ETF like BND. Duration is definitely overlooked.
For those who don’t know what SWVXX is — which would include me! — it’s the ticker for Schwab Value Advantage Money Fund.
Bonds can be a somewhat deceptively complex subject. I appreciate the well written explanation of bond duration. Where I may disagree with you is in your conclusion: “in structuring your portfolio, I would lean heavily on short-term bonds. Since interest rates are unpredictable, I see that as the best route to preserving value.”
Certainly this would be a reasonable conclusion for someone with a short term investing horizon, say 1-10 years. However, for investors with 10, 20, 40 or more years of investing years ahead of them, the longer duration is very likely to provide a slightly higher return (albeit with more fluctuation). As we all know, even .5% or 1% increased return over long periods makes can make a big difference in portfolio value. Bogle, Vanguard and others favor intermediate term bonds (like VBTLX you referenced), as the sweet spot between taking a bit more duration risk to capture that overall higher return. As always with all investing, it depends on your goals, risk tolerance and time frame.
I think investors’ view of bonds depends on whether they’re looking at bonds as a standalone investment or as part of a portfolio. As a standalone investment, I’d probably lean toward intermediate-term bonds, accepting the greater risk in exchange for greater return. But as part of a portfolio, where the goal is to make stocks — the engine of a portfolio’s investment growth — palatable to own, I favor high-quality short-term bonds.
Who decides on the headline for these articles, Jonathan or the writer? Clever!
Sometimes it’s the writer, sometimes it’s me. In this case, it was Adam.
Excellent and straight forward explanation of a complex topic. For now, my bond investments are divided between money market funds and Treasury bills of one year or less duration. I expect to add intermediate term bonds when their yields overtake those of short term bills, but I am leery of long term bonds so will probably avoid total bond index funds.
Beautifully clear explanation. Although I believe in keeping things simple, I avoided VBTLX. I hold a mix of intermediate and short term high grade corporate and Treasury funds in my IRAs, more short than intermediate, plus an intermediate muni fund in taxable, along with around 2% in a junk bond fund. I need to revisit that allocation as I get ready to start decumulation. I’m looking at CDs for the first time.
Thank you again for the clear explanation.
one area of the fixed income market that is sometimes clearly predictable is high yield. When coming out of recession, high yield probably outperforms as spreads tighten
That’s true — but, at that juncture, stocks will likely perform even better. That’s why I’ve never been that keen on junk bonds. They seem like an unhappy, unnecessary compromise between stocks and high-quality bonds.
That is absolutely the finest and clearest explanation I’ve ever heard or read concerning bond valuations, etc, and I get it.
On a totally different topic, however, namely Einstein’s ” Is The Inertia Of A Body A Measure Of It’s Energy Content?”, I am still clueless,is anybody willing to help? ( Both subjects were equally difficult , one down , one to go!)
I’m sure Adam will be tackling that topic next week!
Adam – Great explanation. These factors are why for any fixed-income portion of the portfolio, I prefer actual bonds held to maturity over bond funds. With bonds, you know exactly what you will get, but bond funds have inherent variability. Bond funds are simple, stable and provide lower near-term risk than stocks, but they are not truly “fixed.”
My experience mirrors your comment–I’ve mostly gotten mediocre results at best using bond funds, but very good to outstanding results buying individual bonds. I guess the trade-off is that buying actual bonds does take more time and research, to understand what you are getting, whereas the bond fund is more of a “set it and forget it” approach. This is one case where more complexity may actually pay off. Bond funds are simpler, but there are times where this simplicity comes at a steep price, as we witnessed last year.
I get it that individual bonds can feel safer to own because of the known maturity date. But there should be scant difference in performance between, say, an intermediate-term bond and an intermediate-term bond fund, but the fund does offer the risk reduction that comes with broad diversification. Moreover, while individual bonds offer the illusion of certainty, the fact is holders of fixed-rate bonds don’t really know how much their money will be worth upon maturity — thanks to inflation.
Sure, inflation is a big enemy of individual bonds, but it kills bond funds just as badly, if not (at times) worse. For my purposes, individual bonds–and I’m lumping CD’s, MYGA’s, Treasuries,and other similar instruments in this category–offer just as good a return, without all the drama of the ups-and-downs of the fund. My preference used to be more for intermediate term instruments, and funds, but the collapse of funds like BND last year has me seriously re-thinking that preference. I like Adam’s thinking in this regard; I recall him mentioning that he thought that an individual investor doesn’t need anything longer than 10 years in their portfolio, and that right now much shorter is even more preferable. I think he may be onto something there.
I also freely admit that personal experience colors my preferences,and emotions play a role along with the data. Remember Strong Funds from the ’90’s? I was among those who got burned by that outfit, and it put me right off the idea of owning any sort of bond fund for many years. Fortunately, I’ve since realized the potential of an appropriate fund, run by a reputable and ethical company, and will utilize them when appropriate.
Many thanks for the clear explanation surrounding bond valuation.