Bonds, sanctuary for the old and the prudent, are set on fire
To put the misery into context: This year’s loss so far is three times larger than the worst year ever going back to 1976. The previous worst performance was a 2.9% loss in 1994, according to a widely followed index that measures investment bonds.
So the loss of money on bonds is not only a surprise to many investors, but the scale of this year’s carnage is also a shock.
“There’s kind of this misperception about: Bonds are bulletproof and you can’t lose money,” said Matthew Benson, owner of Sonmore Financial in Chandler, Arizona.
This year’s bond losses are the result of the high inflation sweeping the globe and the Federal Reserve’s response to it. Inflation in general is a bane for bond investors because it erodes the purchasing power of the fixed-payment bonds you will make in the future.
The Fed’s main weapon to reduce inflation is to raise interest rates. But this causes newly issued bonds to pay higher yields, making old bonds in investors’ portfolios suddenly appear less valuable than before. This, in turn, causes the prices of those old bonds to fall.
Any investor who buys a bond and holds it to maturity will still get the full value of his redeemed principal, along with all promised interest payments, assuming there are no defaults. But they will earn more if they have the same principal amount invested in a newer bond with higher yields.
“It’s a challenge and it’s a problem, and it’s something we review with our clients,” said Charles Sacks, head of investment at Kaufman Rossen Wealth. “The optics are not good. Bonds are priced every day, and if you mature in two or three years, you will be paid, but no one wants to see losses along the way.”
Bond prices have often fallen in the past, including as recently as 2018. But even then, bonds usually pay enough interest to offset their lower prices. In 2018, for example, prices for high-quality bonds fell 2.9%. But after accounting for the income they paid, the investors got a positive total return of 0.01%.
Heading into 2022, the bonds were paying less. The 10-year Treasury yield was at 1.51%, for example, versus its average of 2.94% over the past 20 years. This gave investors less protection for price drops.
Some financial advisors respond by sponsoring their wealthier clients with sophisticated alternative products such as private mortgages or funds that use hedge fund-like strategies.
Many investors and professional advisors say that investors should not give up bonds, even with their losses, because they remain a better bet than stocks to fill the role of weight in the portfolio. The old rule of thumb says that the portfolio should be 60% invested in stocks and 40% in bonds, with the share of stocks going up or down depending on the investor’s willingness to risk.
Bonds have held up better this year than the stock market, with the S&P 500 down 16.3% for 2022 as of Monday.
“No one put a bond in their portfolio because they thought it would be the best performer,” Benson said. “You’re not going to get the same 4% to 7% total return on a bond fund that you’re probably going to have over the last 25-30 years. But the reason someone would go into bonds in the first place is because they want to reduce volatility.”
Part of that is because bonds produce stable income, something that retirees and other investors need. Bonds bought today offer more income due to higher interest rates. The yield on 10-year Treasuries has nearly doubled so far in 2022, and recently jumped above 3% to its highest level since 2018.
Just remember that bonds could lose more money, as this year painfully shows.