Should Retirement Savers Own Bonds?

Taylor Schulte: On November 2nd, the Fed approved another 75 basis point rate hike.

But since then, the yield on 10-year US treasury bonds has dropped from just over 4.1% to 3.8%.

In other words, while interest rates set by the Fed increased, bond yields have decreased.

Bonds have been the story of the year. In fact, intermediate-term US treasury bonds are on track for their worst year in history, down close to 11% year to date.

If the year ended today, this would only be the 6th time in over 50 years that intermediate treasuries have had a negative return. And, historically, those negative returns have only hovered around 1% or less.

Given their current year's performance, especially when compared to history, it’s no surprise that investors are concerned about the bonds in their portfolio.

Welcome to the stay wealthy podcast, I’m your host Taylor Schulte, and to help address those concerns, I’m covering three things today.

I’m covering why bond yields aren’t moving in lockstep with interest rates set by the Fed, how long it takes for bond losses to recover, and why retirement savers should maintain exposure to bonds for the long run.

For all the links and resources mentioned today, head over to youstaywealthy.com/173.

The bond market is wildly complex. And the reason for owning bonds is different for every investor.

For some, bonds are speculative. They are bought and sold throughout the day in an attempt to outsmart the markets.

For others, bonds are used to improve risk-adjusted returns during the accumulation phase of life. In other words, adding some bonds to a diversified portfolio can actually reduce risk while improving long-term returns.

For my clients who are in retirement or close to it, bonds are used primarily as a diversifier. For that reason, we only invest in AAA-rated treasury bonds versus riskier corporate or municipal bonds.

You see, the more risk you take with bonds, the more they begin to behave like stocks during catastrophic events.

And during catastrophic events – especially when taking withdrawals from your portfolio – it’s critical to own an asset class that produces a positive return and moves in a different direction than broad-based stocks.

In the academic world, the technical term for this is Crisis Alpha. Crisis Alpha is the excess return an investment earns above cash during severe stock market corrections.

Historically, during catastrophic events – such as the COVID Crash in 2020 or the Great Recession in 08/09 or the tech bubble bursting in the early 2000s – US treasury bonds have produced significantly higher Crisis Alpha than corporate bonds. I’ve covered this at length during my Investing in Bonds series so I’m not going to revisit all of the numbers in today’s episode.

But in addition to isolated events like 08/09, historically, AAA-rated treasury bonds have also been life savers during long time periods where stocks are flat which I covered recently in episode 170 titled “How to Invest During a Lost Decade.” For example, from 2000 - 2009, US stocks were down a cumulative 9%. A negative 9% total return over a 10-year time period.

On the other hand, the Vanguard Intermediate Treasury Bond Mutual Fund (VFITX) returned a positive 91% during those 10 years, while cash in a high-yield money market only returned a positive 33%.

Without a globally diversified portfolio and an allocation to high-quality bonds, a retiree leaning on their portfolio for income would have been in a very challenging position. High-quality bonds were an absolute lifesaver.

But fast forward to this year, a year where stocks were down close to 25% at their low in September and high-quality treasury bonds were also down double-digits. Naturally, investors have been scratching their heads wondering why their bonds have not provided the Crisis Alpha they were hoping for.

There are two main reasons for this.

One, this is not an event that we would necessarily define as catastrophic. Yes, a 25% drop in stocks is less than ideal, but textbook bear market like this happens about every 6 years or so. And as we all know, things can get much worse. In the early 2000s, the stock market was cut in half TWICE. That is catastrophic.

Two, the fed has rapidly raised rates, and bond yields, while not controlled by the Fed, have increased as a result of this rapid policy shift. When bond yields increase, we see a drop in the principle value of bonds. This is the inverse relationship between yields and bond prices most of us are aware of.

But if that inverse relationship exists, then why are bond yields falling following another Fed rate hike?

In short, the interest rate set by the Fed (aka the fed Funds rate) is not correlated to bond yields or future bond returns. The fed funds rate is the interest rate that banks charge each other to borrow or lend excess reserves overnight. It might influence bond yields – especially when the Fed makes a major policy shift and shocks the global markets – but it doesn’t control or decide them.

In fact, one study from Dimensional Funds which I’ll link to in the show notes, concluded that over the last 37 years, there is no reliable relation between past changes in the fed funds rate and future bond returns.

I’ll say that again, over the last 37 years, there is no reliable relation between past changes in the fed funds rate and future bond returns.

So, the fed continues to hike interest rates, yet bond yields are falling. We now know that there is no reliable correlation between the two, so how might we explain why bonds are behaving the way they are right now?

Put simply, investors are piling into longer-term bonds right now. And when there is a high demand for bonds, their yields begin to drop.

Why are investors piling into long-term bonds? Because the economy is weakening and inflation is showing signs of cooling, both of which improve the odds that the Fed will likely reverse course and be forced to lower rates in the next 12-24 months.

Remember, the Fed has made it clear that they are intentionally trying to weaken the economy and drive us toward a recession in an effort to combat inflation. When the economy weakens, investors tend to flock to safe assets like US treasury bonds. And that flock to treasury bonds – the purchasing of these bonds – puts downward pressure on their yield.

To summarize, the Fed is continuing with their rate hikes to slow down the economy and combat inflation. The Fed appears to be accomplishing their goal with a recession looking more and more likely and inflation beginning to show signs of cooling. With the economy slowing down, investors are buying up safe assets like US Treasury bonds, causing their yields to drop even in the face of a rising interest rate environment.

Now that we know why bond yields are going down while the fed continues to commit to raising interest rates, let’s talk about the current state of bonds, why they’re down so significantly this year, and where they might go from here.

Again, intermediate-term treasury bonds are currently down around 11% this year. And while the fed funds rate doesn’t control bond yields, it certainly influences them. Especially when there is a rapid shift in the Fed’s interest rate policy like we’ve witnessed this year, where the fed funds rate has been taken from 0 to an upper limit of 4% in less than 12 months via 6 consecutive rate hikes. 6 rate hikes in 11 months.

Now, in hindsight, one might say this policy shift by the Fed was obvious. That interest rates couldn’t sit at 0% forever and it was clear that rates would be increasing. And given how obvious this was, why would anyone choose to own bonds or bond funds over the last year?

It’s a very fair comment, and one I’ve heard a lot lately, but…I’ll let you in on a little secret here…not even the Fed knew that the Fed was going to be raising interest rates to this extent this year. You heard that correctly…not even the Fed, the organization that sets the level of interest rates in this country, knew that the Fed would be doing what they’re doing right now.

I know this because it’s public information. The Fed regularly publishes their economic projections for the future, sharing their targets for not just GDP and unemployment, but also inflation and interest rates.

And in June of 2021, so just a little over a year go, the Fed projected that the fed funds rate would be between 0.1 and 0.6 in 2022 and 0.1 - 1.6 in 2023. In other words, they projected that there might be 2-3 rate hikes over the next two years. 2-3 rate hikes over the next two years are VERY different than 6 hikes in 11 months.

While some market timers might have had their crystal ball working perfectly, and successfully predicted this year's events, most people, including the Fed themselves, did not see this coming. And this quick, unpredictable pivot in interest rate policy really shocked the markets, sending bond yields higher and bond prices lower.

So, yes, in hindsight, it’s easy to kick ourselves for owning bonds and it’s easy to say that we should have seen this coming, sold our bonds, and stuffed everything under the mattress. But that would require a crystal ball, a crystal ball that not even the Fed had access to.

For some reason, it’s easy for most of us to acknowledge that timing the stock market is impossible, and therefore it’s best to buy and hold low-cost index funds versus actively trading stocks. But when it comes to bonds, cash, and CDs, investors seem more confident about when to shift in and out of these “safe” asset classes.

And while they are, typically, safe asset classes, they are far from simple and an investor can get themselves into just as much trouble trying to time them as they can with stocks.

So, we now know that bonds are down significantly this year because of the fed's unpredictable rapid policy shift. While the fed funds rate doesn’t determine bond yields, the rapid increase in interest rates did influence bond yields to follow suit, with the 10-year treasury going from 1.77% to as high as 4.2%. And when bond yields rise this rapidly and significantly, bonds and bond prices suffer losses...losses that are predictable.

I use the word predictable here because I’m only talking about AAA-rated US Treasury bonds. These bonds, unlike corporate and municipal bonds, don’t contain any credit risk, allowing their future returns to be more predictable – another bonus to owning them in addition to the Crisis Alpha that we talked about earlier, especially for those in retirement.

Now, while treasury bonds don’t contain credit risk, they do contain duration risk – the risk that changes in interest rates will cause their prices to go up or down. For that reason, when we are allocating to US treasury bonds or US treasury bond funds, we want to be sure that we match our investment time horizon with the duration of our bonds. By doing so, we can fairly easily predict the future performance of our bond portfolio allowing us to properly build a plan around them.

Let me try to break down how US treasury bonds are predictable using a hypothetical scenario that more or less represents what we’ve witnessed this year.

Let’s say that on January 1st of this year I put $100,000 into a US treasury bond portfolio with a yield of 1% and a duration of 5 years. Immediately after making this investment, let’s say that similar to what we have witnessed this year, bond yields jumped to 4% overnight and then remained at 4% for the next 10 years.

Well, this jump in yield from 1% to 4% would cause the value of my bond portfolio to drop by almost $14,000. My $100,000 is now worth $86,385 due to the immediate rise in yields. But, guess what, now my bond portfolio with a duration of 5 is paying a higher yield, and since we are assuming yields don’t move again in this simple example, I know with certainty that in exactly 4 years, my bond portfolio will have recovered. And by year 10, my $100,000 would be worth almost $128,000.

On the other hand, if bond yields never changed after making my $100,000 investment, and rates remained at 1% throughout the same 10-year time period, I wouldn’t have had to deal with a significant price drop in the first few years, but, I would have also ended the 10-year period with significantly less money.

My bond portfolio in this example, where rates stick at 1% and don’t change, would only be worth about $110,000 in year 10 versus $127,000.
In the short term, the duration risk I was taking stung a little bit, but the higher yield over the remainder of my investment time horizon quickly made up for those early losses.

Bringing this back into today’s current situation where US Treasury bonds are down about 11%. Yes, it’s not fun to see our bonds down double-digits, but we now know that we will recover from those losses in just a few short years even if yields don’t change as those higher-yielding bonds begin paying us higher coupons. Assuming we own AAA-rated US government bonds, our future returns are quite predictable.

The real problem or risk that exists is if your bond duration is longer than your actual investment time horizon. For example, if you bought US treasury bonds as a cash equivalent for your emergency fund, you’ll be forced to sell your bonds at a loss if you need a new roof tomorrow or have an unplanned medical emergency.

But if your duration is matched up with your time horizon, you can simply acknowledge that it’s painful to see bonds perform like this in short term, and then remind yourself that it’s fairly easy to figure out when they will recover, assuming they are treasury bonds and not riskier corporate or municipal bonds.

Now, you might already be thinking this, but bonds can also recover if their yields go down. When yields go down, bond prices go up. And that’s what we’ve seen since the fed last raised interest rates on November 2nd. As stated earlier, 10-year treasury bond yields have actually fallen since the fed last increased rates. And this drop in yield has sent the Vanguard intermediate-term treasury bond fund up by 2% just this month.

So, if investors continue to pile into US treasury bonds, sending their yields even lower, it might only take months for your bond portfolio with a duration of 5 to recover versus 4 years like the example I walked through earlier.

And that’s where things get a little less predictable here in the real world, we know how a treasury bond portfolio will perform when the yield changes, but we don’t know when and how yields will change. That lack of certainty in future yields is precisely why I think retirement savers should continue to own bonds – specifically plain vanilla US treasury bond funds – even in light of this year's historically poor performance. We don’t know what is around the corner and what will happen in the future.

While interest rates likely won’t go back to 0 unless something really crazy and catastrophic happens, it wouldn’t be totally out of the realm of possibility for 10-year treasury yields to drop by 20-40% from current levels as it looks more and more likely that the Fed is accomplishing their goal of steering us toward a recession. If that were to happen, your boring US treasury bond fund is going to be a lifesaver for your portfolio, especially for those relying on their investments to produce a retirement paycheck.

And if that doesn’t happen, and rates remain at today’s level and don’t change, well, we still know with certainty how long it will take for our AAA-rated treasury bonds to recover and what their future long-term returns will be.

Lastly, before we part ways today, one question that continues to come up when talking about bonds and their current performance is if investors should consider bank CDs instead of bond funds going forward. It’s a good question because banks are advertising very attractive CD rates at levels we haven’t seen in years. And it’s not surprising that investors are responding positively to these offerings given how starved for yield they’ve been.

But there are 5 things to take into consideration here when considering CDs as a bond fund alternative.

First, if you buy into a 5-year CD ladder – the longest I typically see people go – the duration of your CD portfolio will be 2.5 years. In other words, when compared to a US treasury bond fund that has a duration of 5 years, you have to expect a lower future rate of return and therefore have to potentially reduce your withdrawal rate if you’re leaning on your investment portfolio for income in retirement.

Second, on that note, buying bank CDs and spending the interest earned is a different philosophy than buying and holding bond funds that are part of a diversified portfolio. The former is what we call an Income Approach and the latter is my preferred methodology which is often called a Total Return Approach.

With an income approach, you spend the income earned from your investments and don’t touch the principle. With a Total Return Approach, every investment is constantly working together, with dividends and interest payments being reinvested, in an attempt to appropriately manage risk and target a desired long-term return. Unlike the Income Approach, withdrawals using a Total Return Approach are based on an identified sustainable withdrawal rate and the withdrawals are pulled each month or each quarter from the highest-performing investments first.

While there are strong arguments for both philosophies, Vanguard has published a few articles and studies that conclude that an Income Approach to investing leads to an inappropriate risk exposure for investors and a Total Return Approach is QUOTE “A superior approach for income investments.” Vanguard also states that “A total-return approach helps to minimize portfolio risks and maintain portfolio longevity while allowing an investor to meet spending goals with a combination of portfolio income and capital.”

While Vanguard's conclusions are compelling, the most important thing is that you find a philosophy that you agree with and stick with it for the long-term. So, if income investing is your preferred methodology to producing income in retirement, then sure, buying and laddering individual CDs or even individual bonds would certainly support that.

Third, with CDs, you’re giving up Crisis Alpha that, historically, has been delivered by high-quality treasury bonds during catastrophic events. And, in retirement, that Crisis Alpha can be very much needed to sustain long-term withdrawals from the portfolio, especially in the first 10 years of retirement.

Fourth, buying a AAA-rated bond fund with a duration that matches your investment time horizon also helps to remove the guesswork and emotions from investing. If I’m buying and laddering bonds or CDs, I’m forced to make a decision every time one of those holdings matures.

Depending on the interest rate environment at the time that holding matures and depending on how I’m feeling on that given day about my financial situation or the state of the economy or where rates are going next, I might be lured into making a market timing decision that can hinder my future returns. The good news is that there are automated services that can do all of this for you which will help to ensure you don’t get in your own way if this is the route you choose.

Still, don’t forget about point #1, that the duration of your laddered CD account is likely lower than an intermediate-term treasury bond fund, meaning you have to expect lower future rates of return.

Lastly, bank CDs can be callable, meaning the bank can give you your principle back before your maturity date, forcing you to go and buy a new CD at likely much lower rates. They wouldn’t call your CD if rates went up, this usually happens when rates go down from where you purchased.

In any event, callable CDs (and callable bonds) can cause your future returns to be less predictable. And while it doesn’t mean you should avoid bank CDs at all costs, it’s important to look under the hood and understand if the CDs you currently own or are considering are callable so that you can take that into consideration in your planning.

In conclusion, bank CDs can be a great choice, but they are primarily a cash alternative. When considering them as a bond fund alternative, there are a number of important nuances to take into consideration before jumping in feet first.

As noted at the top of the show, the bond market is wildly complex. Which, just like the stock market, leads me to conclude that trying to predict the future of bonds and interest rates is a losing game in the long run. That trying to time the bond market or pretend I know when it’s best to own a bond fund vs a bank CD vs cash under the mattress is likely going to lead to lower future returns.

It’s been an extremely challenging year in the market, especially for bond investors who had very different expectations from their fixed-income investments. But just like any other downturn in the markets, it’s important that we stay committed to the plan we worked so hard to put into place and trust the process. Be patient, stay the course, continue to get curious and study history, and most of all, stay focused on investing for the next few decades, not the next few months.

Once again, to grab the links and resources mentioned in today's episode, just head over to youstaywealthy.com/173.

Thank you, as always, for listening and I will see you back here next week.

Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.