Bonds had a terrific November. But that followed a dreadful multi-year run that was the worst in bond-market history.
On today's Faith & Finance program on American Family Radio, SMI's executive editor Mark Biller explains why rising interest rates have battered bonds so severely, and he discusses the bond outlook for 2024.
Click the arrow below to listen. Scroll down for a transcript.
(For more radio appearances by members of the SMI team, visit our Resources page.)
"My approach to bonds is pretty much like my approach to stocks. If I can't understand something, I tend to forget it." That from Warren Buffet.
Hi, I'm Rob West.
Well, if the "Oracle of Omaha" thinks bonds can be difficult to understand, you shouldn't feel bad if you need someone to explain these fixed-income securities to you! Fortunately, we have Mark Biller with us today to do just that. Then it's on to your calls at 800-525-7000.
This is Faith & Finance on American Family Radio — biblical wisdom for your financial decisions. (theme music ends)
Well, let's face it, bonds are a little mysterious to many people. For example, when interest rates rise, bond prices go down. What's up with that? Well, Mark Biller's going to make bonds a lot more understandable in the next few moments. He's executive editor at Sound Mind Investing, where they have a knack for getting down to the basics.
Great to have you with us, sir!
Thanks, Rob. Good to be back with you.
Now we're talking bond basics today and folks can of course read more about it on your website: soundmindinvesting.org. You have an article titled Duration, A Simple Way to Gauge Bond Risk.
Now, we probably don't need to point out that things have been pretty tough for bond investors recently, huh?
Yeah, that's certainly true, Rob. Y'know, after a decade or so of the Fed and other global central banks pushing interest rates down to historic lows and then holding them there, the last three years have been quite a shock to bond investors.
For example, the 30-year Treasury bond yield bottomed at just under 1% back in 2020 just after COVID. But that yield has soared all the way up to 5% recently. And, as a result, owners of long-term bond funds have had cumulative losses of roughly 50% over the last three years. Now, that rivals the worst stock market declines that we saw during the big bear markets back in the [early] 2000s.
Yeah, that's a huge hit, especially when you've got a lot of retirees counting on bonds. So how does something like this happen, Mark?
Yeah, well, to answer that, Rob, we kind of need a crash course. Let's call it Bond Investing 101.
So when you buy a bond, which is essentially a glorified IOU, you're acting as a lender. So you're lending your money at interest to a company, an organization, a government. Now, that's in contrast to when you buy a stock because then you're acting as an owner — you're buying a partial equity stake in a company. So very different things, owning stocks versus bonds.
Now, there are two major risks when it comes to buying bonds. The first is called credit risk, and that speaks to the idea that you might not get all your money back. You're counting on the borrower to be creditworthy and to keep making the interest payments and pay off the bonds when they mature. Now, the most common way to minimize credit risk is, one, lend to really creditworthy institutions, and then, two, you spread your holdings out among lots of different bonds, which is exactly what bond mutual funds do. So that's credit risk.
Now, the second major risk for bondholders — and this is the one that's been causing all the trouble lately — is interest rate risk. And that's the possibility that you can get locked into a below-market rate of return. So this is really the same risk that you face when you're trying to decide how long to tie up your money in a bank CD, but it has a lot more significance when investing in bonds because with a CD, you might be locked in for a year. So if rates rise after six months, it's a bummer because you're at a below-market rate for six months. But with long-term bonds, you can be locked in for years and years and years.
And so because of that, if you want to sell a bond that's been saddled with what's now a below-market interest rate, you're going to have to drop the price of that bond in order to entice a buyer to buy it. And so that's why you pretty much have this iron rule: "When interest rates go up, bond prices go down."
The longer you have to wait until a bond matures, the longer you're vulnerable to this interest rate risk.
Now, the shorter the maturity, the less volatile a bond's price will be. And, likewise, the shorter the average maturity of all the individual bonds held by a bond fund, the less volatile that fund's price will be. And that's why one of the ways you can reduce risk when you own bonds is to lean towards shorter-maturity bonds instead of longer-term bonds.
And that's one of the key takeaways to keep in mind as we talk about this today.
Now, this is where we really get into the title of this month's article at soundmindinvesting.org, which really focuses on this idea of bond duration.
Yeah, that's exactly right. And while the exact details of that can get a little complicated, suffice it to say that the shorter the average length of a bond fund, the less it is likely to move in response to changes in interest rates. So like we just said, one way to reduce risk when you're investing in bonds is to go to short-term bonds rather than long-term.
Now, this article that we're talking about this month, Rob, it has a full explanation of duration for listeners who really want to dig into this story. But one of the most interesting little aspects of this for most listeners is going to be that the duration of a bond fund can tell you roughly how much a fund's value is likely to change if interest rates move up or down.
So the rough rule of thumb here — we love rules of thumb, I know — for every 1% change in interest rates, a bond fund's price will usually move in the opposite direction by the fund's duration. So for example, if you're looking at a short-term bond fund with a duration of three, that means that if interest rates go up by 1%, that fund will likely fall by 3% the amount of the duration.
Now, if you look at a long-term bond fund with a duration of, say, 10, that means that a 1% move in interest rates would cause that fund to fall by 10%. And that's how we get to those huge losses that I talked about earlier for long-term bond funds. Shorter-term funds have also fallen in the last few years, but not nearly by the same degree.
So when you're talking duration of "3" or "10," those would be years, correct?
Yeah, that's right. The average length in the fund of all the bonds in the fund. Yep.
So the duration obviously corresponds with that move in interest rates and can give you an idea of what's going to happen to the price as it moves.
Now, what about the role of inflation in bond prices?
Yeah, so now we're getting into the really good stuff. So inflation and interest rates are directly related because the primary tool that the Federal Reserve and other central banks around the world use to combat inflation is they raise and lower short-term interest rates.
So if we think of inflation as "too much money chasing a certain number of goods," when the Fed raises interest rates, people now have to use more of their money to pay interest expense, which reduces the amount of money that's chasing those goods. And that's what relieves the pressure driving inflation and prices higher.
So higher inflation is normally going to produce higher interest rates. Then as interest rates go up, bond prices fall. So it's no surprise then, Rob, that inflation is the boogeyman that bond investors lie awake at night dreading.
All right, so then the big question investors want to know is, where do bonds stand today?
Yeah, y'know, it's tricky because when bonds were yielding 2%, a lot of people said, "Well, that's it. They're not going to go to 3." Then they hit three. They said, "Well, we'll never go to 4." And then the 10-year treasury bond hit 5% in October. There are a lot of people saying, "Well, now we're done. The peak is in." And that may be true, they have come down quite a bit in November. But I still think it's a little early to rule that out.
But I would also say, Rob, bonds have had a massive repricing over the last three years since COVID, and with them down so much — anytime you see a major asset class go down 50%, as an investor, you've got to look there and say, well, "Ws that an opportunity?" So it's hard to buy when you're down a lot, but history shows that's often a great time to buy.
Exactly right. Well, we'll get Mark's take on where bonds go from here. What's the outlook, especially in light of a possible recession next year? Stick around.
All right, Mark, we started today by talking about bond basic, and you gave us really a helpful background on how the prices of bonds move and the effect of interest rates and inflation. You talked about where we stand today and this idea that because we've seen bonds decline so much, that typically — at least historically — speaking, that means that bonds are in a great buying position.
But given that, what would you say is the outlook for bonds? Of course, lots of analysts are saying we'll have a recession next year at some point, even if it's a mild one. So what would that do for bond prices?
Yeah, and that's a big point, Rob. A lot of this does hinge on that recession or no-recession situation. And that's because during recessions, the Fed almost always cuts interest rates, and usually quite substantially. And we started off talking about how when rate hikes happen, bond values fall. Well, the opposite happens when they cut interest rates, bond values tend to rise.
So we've got a setup where bonds have already come down a lot, and as we look forward to next year there's a pretty good chance that we could see falling interest rates, which would be good for bonds.
Now, of course, if we don't get a recession, then the script probably flips back the other way. No recession probably means we have continued inflation pressure and that probably means that interest rates stay up.
So you don't want to necessarily run out and load up on the riskiest long-term bonds right here because you're thinking that interest rates are going to come down in a recession. There's always a chance it's not going to turn out that way.
But I would say, overall, I'm very favorable on bonds moving forward from here. And if you've got a diversified portfolio that has a good mix of short- and intermediate-term bonds, I definitely would not be reducing those right now, even though the performance on those has not been very good the last couple of years.
You have to think about, "Why are they in my portfolio in the first place?" And the big reason most people own bonds is to reduce — or offset — the stock market risk that they have in their portfolio. And now, when you couple the bond losses we've already seen and the possible recession set up for next year, I think that a lot of the stars are aligned for bonds to do really well.
So at a minimum, I would be maintaining those allocations. And for people who've been frightened and scared into savings and CDs and that kind of thing, you could even be thinking about how over the next several months it might make sense to transfer some of that money into short- and intermediate-term bond funds to lock in some of today's higher yields in case those yields start to come down next year during a recession.
Yeah. So if you were somebody transitioning into retirement — let's say you were building that 60/40 portfolio we talk about a lot, 60% bonds, 40% stocks — what specifically would you put in that bond portion for the average person? You're saying "short to medium term," so give us some definition around that.
Yeah, so intermediate-term bonds — typically we're talking about 3- to 7-year maturities. But for a lot of people you just want to find the intermediate-term bond fund in your 401(k) or other plan. Those have typically been the bond market "sweet spot" where you get a lot of the better return of longer-term bonds without having the risk associated with truly long-term bonds.
So SMI has always said intermediate-term bonds are really the market sweet spot. And if we do see that recessionary type of pulse next year, intermediate-term bonds are going to do better than short-term as interest rates fall.
So I would say to have a mix of short-term and intermediate-term bonds — that could be roughly a 50/50 blend between the two. If you are really thinking that recession is very likely and you want to try to capitalize on that, you could tilt a little more heavily to intermediate-term.
Now of course, if we do have a recession, long-term bonds are going to perform the best, but you got a lot of risk there. And I think you can really do well in intermediate-term bond funds without going all the way out to long-term.
So a good blend of short- and intermediate-term is really where I think most listeners probably want to be.
Yeah, that's really helpful. And then, quickly, just your take on where we head from here. It looks like the market has really priced in the Fed's starting to aggressively cut rates next year — except if corporate earnings hold up, and the consumer holds up, and the job market holds up, I suspect they're going to be leery of reigniting the inflation fears.
So where do you think we're headed — in just in 30 seconds or so?
Yeah, and so because of that, I wouldn't put all my apples in the rate-cut basket. But the good thing is right now with rates where they are today — even if they just hold rates — short-term and intermediate-term bonds are producing a lot of income. So they're a good place to be right now, even if they don't cut, and they're an even better place to be if they do cut next year.
Now, that's really helpful.
All right, Mark. Well as always, a lot of great information. So thankful for our partnership with SMI and really appreciate your insights today on bonds. Merry Christmas, my friend!
Thank you. You as well, Rob.
All right, that's Mark Biller, executive editor at Sound Mind Investing. Check out this article we've been talking about, Duration: A Simple Way to Gauge Bond Risk. And learn a whole lot more when you visit soundMindInvesting.org.
I'm Rob West. Thanks for being with us today on Faith & Finance here on American Family Radio.
Check us out online: FaithFi.com!
AFR Disclaimer: The views and opinions expressed in this broadcast may not necessarily reflect those of the American Family Association or American Family Radio.