Structuring Bonds

IT’S BEEN AN UNUSUAL week in the bond market, and not necessarily in a good way. This has many investors questioning the value of bonds, which is understandable. Bonds are supposed to be the “safe” side of a portfolio, but they’ve struggled in recent years.

Arguably, the drama we’re seeing in the bond market today began more than 50 years ago. To put today’s situation in perspective, I’ll briefly summarize that long history. Then we can look at what steps you might take to better protect your portfolio from here.

Back in the 1970s, as you’re probably aware, inflation rose above 10%. Policymakers struggled for years to bring it under control, but in the early 1980s a Fed chair named Paul Volcker finally succeeded. He accomplished that by raising the Fed’s benchmark rate to nearly 20%. With this step, Volcker succeeded in calming inflation, and that allowed the Fed to begin lowering rates, a gradual process that continued for most of the following 40 years.

Because bond prices move inversely to interest rates, that entire stretch was extremely beneficial for bonds. As rates fell, bonds rose. Between 1980 and 2020, intermediate-term U.S. government bonds returned 7% per year, on average. That multi-decade run helped seal the reputation of bonds as an easy and reliable way to offset the risk of stocks.

But then the other shoe dropped. Due to pandemic-related government spending and tangled supply chains, inflation began rising around 2021. Well aware of what the economy experienced in the 1970s, the Fed responded by raising rates aggressively. For a time, that appeared to bring inflation under control, and the government had even started to lower rates again last year. But then the war with Iran started. That caused energy prices to jump higher, and that, worryingly, has caused inflation to start creeping back up again.

In response, the Fed this week was forced to take action, raising rates in an effort to contain inflation before it gains steam. Interest rates on long-term bonds are now at 20-year highs. And because bond prices move inversely to interest rates, bonds are having another difficult year. Total-bond market funds like Vanguard’s BND are now negative year-to-date.

Where the bond market goes from here is anyone’s guess, but this history is important, in my view, because bonds are unlikely to see another long, positive stretch like the one investors enjoyed a generation ago. Instead, I believe investors need to be more cautious. 

What steps might you take? Since we don’t know whether rates will go higher or lower over any given timeframe, the approach I recommend is to own bonds in each of several categories. That way, you’ll benefit, in part, if rates go up, and you’ll benefit, in part, if rates go down. Here’s how I’d structure a bond portfolio today:

For me, the most important thing is to own mostly short-term bonds. Specifically, you might allocate 60% of your bond portfolio to short-term Treasurys, using a fund like Vanguard’s VGSH. This fund should be among the most stable investments available because it’s backed by the U.S. government, which, for better or worse, has the ability to print money to meet its obligations. And its short duration means that, all things being equal, it will be less susceptible to rising interest rates if rates do continue to rise. As a point of reference, in 2022, when rates rose quickly, this fund lost less than 4% of its value. That’s in contrast to total-bond market funds, which lost an extremely unpleasant 13% that year.

If you’re in a high tax bracket (over 30%), you could split your short-term holdings between Treasurys, which are taxable at the federal level, and municipal bonds, which are exempt from federal tax. You might consider a short-term municipal fund like Vanguard’s VTES or VWSUX.

Next, I’d allocate 20% to intermediate-term bonds. While these will be more susceptible to losses when rates rise, they’ll also gain more when rates fall. Last year, for example, when rates fell, intermediate-term government bond funds like Vanguard’s VGIT gained more than 7%. So I see them as worth the additional risk.

That said, if this risk concerns you, there’s a relatively easy alternative: For this part of your portfolio, you could purchase a ladder of individual bonds covering maturities between five and 10 years. While it requires additional effort to purchase individual bonds, what you’ll receive in return is greater certainty. At the moment that you purchase an individual bond, you’ll know the yield to maturity. Barring a default—which is unlikely with a government bond—that’s precisely the return you will earn.

For the final 20% of a bond portfolio, I recommend inflation-protected Treasury bonds, known as TIPS. Here again, you could purchase individual bonds or a bond fund, and there’s a lot of debate on this topic. But according to research I find convincing, the best way to protect against inflation is with short-term TIPS. So to keep things simple, I would opt for a fund rather than a ladder of individual bonds, which would require frequent trading. One good fund in this category is Vanguard’s VTIP.

At the end of the day, the most important thing, in my view, is to build a bond portfolio that’s diversified enough that you could reliably draw on it in years when stocks are down. And recognizing that even short-term bonds carry some amount of risk, it’s worth also holding a “floor” of cash, using a government money market fund, as an additional element in your portfolio. These won’t gain in value when interest rates fall, but they’re designed not to lose any value if rates rise.

Put it all together, and I see this as an effective sleep-at-night structure no matter where things go next.

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 X @AdamMGrossman and check out his earlier articles.