Don't give up on bonds and bond funds

As you’re probably aware, 2022 has been far from rosy with regards to the performance of most of the financial markets.

As of the writing of this newsletter, the US stock market (as measured by the S&P 500) is down about 22% year-to-date. Additionally, the US bond market (as measured by the Bloomberg US Aggregate Total Bond Index) is down about 13%.

While it’s not enjoyable to say, the decline in the stock market isn’t a surprise. As I’ve expressed before, it was long overdue.

The S&P 500 returned +31.5% in 2019, +18.4% in 2020 and +28.7% in 2021. At the beginning of each of those years, I told myself I wouldn’t be surprised if that was the year the correction finally happened. Well, it took a few more years for it to finally arrive, but here it is.

As much as it’s painful to see the “bear market” decline in the stock market play out, it’s not a shock. Furthermore, it’s actually healthy from a longer-term perspective for things to cool down and come back to earth. The S&P 500 today is at about the same place it was at the beginning of 2021, which is a much more reasonable level than the all-time peak it hit in early-January of this year.

While the stock market decline is ultimately not a surprise, the bond market decline is a bit different of a story.

Bonds are not riskless, but – depending on the type of bond(s) – they should generally at least be less risky than stocks. Bonds were never meant to generate massive gains or income. They should be intended to be used as a “volatility dampener,” meaning their gains or losses should typically be more muted than those of stocks.

Additionally, bonds will generate at least SOME income. Though in recent years, considering how low interest rates have been, there wasn’t really much income to be had in most cases.

As a whole, the price of bonds or funds that invest in bonds moves inversely to changes in the market level of interest rates. All else equal, as interest rates go up, bond prices go down. And vice versa. For more information about bonds and how they interest with interest rates, check out my YouTube video, Bonds, Bond Prices and Bond Yields.

For example, the US total bond market (which is a mix of mainly US Treasury bonds, but also some investment-grade US corporate bonds, some US mortgage-backed bonds and few other smaller positions) had unusually large gains in 2019 and 2020. This was due to the decrease in interest rates during those years.

Specifically, the interest rate that most impacts the price of the US total bond market is the yield on the 10-year US Treasury bond. As that yield decreased during 2019 and 2020, the US total bond market returned +8.7% and +7.7%, respectively.

However, as the pandemic began to wane and inflation ramped up, interest rates have risen. The 10-year US Treasury yield is currently about 3.9%, up from its pandemic low of about 0.5%. That rapid increase in rates has led to a fairly sharp and swift decline in the US total bond market, which lost 1.7% in 2021 and is thus far down about 13.7% year-to-date.

Just like no one can predict the timing of when the stock market will go up or go down, no one can predict the timing of when yields on the 10-year US Treasury bond will go up or go down. While the yield on the 10-year Treasury is at its highest level in over a decade, it’s widely expected throughout the industry that it will start to decrease again. Nobody knows when exactly it will happen, but there is no strong reason to think it won’t decline once inflation finally breaks and/or economic recession or economic difficulties occur.

If/when yields on the 10-year US Treasury bond do start finally coming back down, the US total bond market (and funds that seek to track it) will start increasing in price. With that said, don’t give up on your bonds or bond funds!