Bonds are starting to recede into the background where they belong, not even trying to compete with the prima donna of the investing world, stocks, as a source of steady income.
Bonds’ mediocre performance in the first half of the year was seen as a big improvement. Over the past three years, bonds have too often attracted attention for the worst reasons.
But now, with annual inflation falling, the fundamental outlook beyond 2024 looks brighter than ever for bonds. If you have cash parked in money market funds paying 5% or more a year, you might want to start planning ahead, because those attractive short-term rates could soon start to fall — while still giving you a big bonus on bond yields.
But with uncertainty about the country’s political future growing since the Trump-Biden debate, there are already signs that the bond market may be in trouble. Here are some key factors to consider and how to address them.
Bad Times
First, let’s cover some investment basics.
Stocks are risky. I’ve always known that, and I’m prepared to take periodic losses in the hope of superior returns in the long run. But what about bonds? Bonds are supposed to be safe, a comfort when the stock market brings pain.
Bonds have been anything but comforting over the past few years. The markets have been so bad that it’s sometimes hard to believe that bonds are even worth owning. Look at the numbers.
Core bond funds that mirror the Bloomberg Aggregate Bond Index, a major investment-grade benchmark, were hit hard from the start of 2022 through October of that year as inflation soared and interest rates rose. The index fell more than 15% over the period, including interest and dividends, and funds that track it, such as the Vanguard Total Bond Market Index Fund and iShares Core U.S. Aggregate Bond ETF, fell as well.
At the same time, the S&P 500 fell nearly 18%, including dividends. Bonds did not stabilize portfolio returns during equity market declines, but instead made things worse.
Bond yields have improved since then, but not by much. The core bond index is still down slightly in the first half of the year, falling into the red by 9% from the start of 2022 through July 3.
To be fair, bonds were a good investment in limited circumstances, even during these tough times. High-quality bonds can’t lose money if held to maturity, so individual bonds worked well for limited time periods and purposes, like safely storing money until you were ready to buy a house or send your kids to college. Solid bonds — Treasuries, investment-grade corporate bonds, and high-quality municipal bonds — also worked for people who needed a secure income in retirement.
But bonds and bond funds have a broader purpose than that, as a permanent part of a diversified portfolio, and in that respect they have been disappointing.
What has changed?
But history suggests that what we just experienced is rare. With the notable exception of potential market turmoil resulting from the presidential election, this ordeal appears to be largely over.
Let’s start with the core issue of the bond market.
Consider how well bonds have performed over the long term: From Jan. 30, 1976, through June, the Bloomberg Aggregate Bond Index rose 6.5% annually. From 1984 through 2021, bond market returns were positive almost every year.
Interest rates and inflation are very important for bonds, and for people buying bonds, interest rates and inflation have improved significantly.
This can be confusing. Higher yields mean higher income for bondholders. This is a problem for investors because when interest rates and yields rise, bond prices fall. This is why bondholders and bond funds have suffered losses in recent years.
During the 2008-2009 financial crisis, short-term interest rates controlled by the Federal Reserve fell to near zero, while market-driven interest rates on long-term bonds also fell. While lower interest rates generated big gains for bonds at the time, they were also the root cause of the carnage of the past few years as inflation and interest rates soared.
We currently live in a more benign environment, both in terms of inflation and bond yields. Inflation has not been overcome, but it has been contained.
At the same time, yields are already quite high: The 10-year Treasury peaked at about 5% in October, and the market consensus is that it’s unlikely to surpass that level again anytime soon. At the current trading range of 4% to about 4.5%, “the 10-year is a bargain,” said Jeff MacDonald, head of fixed-income strategy at Fiduciary Trust International, a unit of asset manager Franklin Templeton.
He said yields on many taxable and tax-exempt bonds will likely fall a year from now, which will lead to higher bond prices in addition to the income the bonds generate.
Additionally, if you have cash parked in money market funds, where 5%-plus yields are the norm, you might want to consider moving some of your money into bonds or bond funds. The Fed’s own projections indicate that it will begin to cut short-term interest rates by the end of the year, at which point money market fund yields will begin to fall rapidly and it may be too late to lock in attractive bond yields.
Gennady Goldberg, head of U.S. rates strategy at TD Securities, said that if the economy starts to slow, interest rates could fall “faster and lower than the market currently expects,” and that “it makes sense to get ahead of that.”
But the election
The stock market has barely reacted to the election questions, but the bond market has.
Immediately after the debate, long-term bond rates rose sharply in response to a clear increase in the election prospects of former President Donald J. Trump and the Republican congressional candidates, while the outlook for Democrats deteriorated.
These rising rates likely reflect concerns that Trump could control not only the presidency but also Congress, which could lead him to push for more sophisticated and far-reaching policies like tariffs and tax cuts that would significantly increase the budget deficit — all of which could lead to higher inflation and interest rates.
Bond yields have since fallen somewhat, and the political situation is in flux. It is no longer clear whether President Biden will be the Democratic nominee. Please proceed with caution.
When interest rates change rapidly, some bonds are more vulnerable. Remember, when interest rates rise, the prices of long-term bonds fall more quickly than short-term bonds. It’s risky to put a lot of money into long-term bonds right now. And high-yield bonds, also known as junk bonds, aren’t a good option when the bond market goes into turmoil.
The Bloomberg U.S. Aggregate Bond Index tracks the conservative part of the market. It has a duration (sensitivity to interest rates) of about six years and includes only Treasury bonds and high-quality investment-grade bonds. You should be cautious about buying any bonds or bond funds that are riskier than this at this time.
In fact, if the political situation becomes more volatile, holding cash in a money market fund, savings account or other safe place may be a wise temporary move.
But bonds, especially Treasuries, can be a haven in times of real crisis. That’s a perennial reason to hold bonds. But bonds are at their best when they’re quietly doing their main, unglamorous job of generating income and mitigating the volatility of an equity portfolio. I hope the political world will allow bonds to become unbearably boring.
