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Long and Short of It

Adam M. Grossman

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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