Are Bonds Still a Good Idea?

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Contributor, Benzinga
June 8, 2022

The 40-year bond bull market came to an end in 2022, washing away the protection investors enjoyed through employing high bond allocations in their portfolios. 

Year-to-date (YTD), the iShares 7-10 Year Treasury Bond ETF (NASDAQ: IEF) is down over -10%, with the iShares 20+ Year Treasury Bond (NASDAQ: TLT) drawing down even more at a -20% loss. In contrast, the SPDR S&P 500 ETF Trust (NYSEARCA: SPY) lost just over -13%.

Traditionally, a diversified portfolio was thought to comprise two main components: stocks and bonds. For stocks, a global allocation of broad market indexes covering all capitalizations and sectors was thought to be sufficient. For bonds, an allocation to investment-grade corporate debt and U.S. Treasuries was considered adequate.

Investors used the bond allocation to reduce portfolio volatility and drawdowns. In the event of a market crash, bonds can maintain their value or even soar, allowing investors to rebalance into pummeled stock positions. But what do investors do with their portfolios when bonds fall in unison?

Why are Bonds Falling in 2022?

To understand why bonds have suffered so badly, investors need to understand the economic drivers of their behavior. An important factor is changes in interest rates, as defined by the Federal Funds Rate (FFR). This is the interest rate set by the Federal Reserve (the “Fed”) at which banks can charge each other to borrow or lend excess reserves overnight.

The Fed recently raised the FFR by a series of 50 basis-points (0.50%) hikes to quell inflation, which hit a 8.3% year-over-year (YoY) increase in April alone. In addition, the Fed began quantitative tightening, a process where they sell government debt on its balance sheet. This is a direct reversal of its earlier quantitative easing policies designed to stimulate the economy during the COVID-19 downturn. 

The results? Bond yields have skyrocketed. YTD, the benchmark 10-year Treasury note yield has jumped by over 74%, hitting a 52-week high of 3.167% briefly. The post-Memorial Day trading session on May 31 saw a 3.68% increase in the 10-year yield alone, which sent bond prices plummeting that day. 

Bond prices are inversely related to yields, and by extension of that, changes in interest rates. A concept called modified duration governs this. It’s defined as the price change of a bond given a 1% change in interest rates (up or down). The higher a duration, the more sensitive a bond’s price is to interest rate changes. For example, a bond with a 10-year duration would lose approximately 10% in value if interest rates increased by 1%. 

Therefore, 2022 has been a confluence of the worst possible conditions for bonds: higher-than-expected inflation, a series of aggressive rate hikes not entirely priced-in by the market and soaring Treasury yields. Investors holding a balanced 60/40 portfolio have drawn down nearly as much as those holding a 100% equity position. 

Why Don’t Bonds Work Anymore?

Bonds (especially U.S. Treasuries) have traditionally worked well as a complement to stocks in a portfolio to hedge against equity risk because of the following factors:

  1. They produced an overall positive expected return if held to maturity because of the coupon interest paid.
  2. U.S. Treasuries are considered risk-free in terms of default, making them a safe asset for investors to flee to when turmoil strikes (the flight to quality).
  3. Treasuries historically had a low-to-negative correlation with stocks and decent volatility, which, in line with modern portfolio theory, made them a good asset for diversification.
  4. When a market crash occurs, the Fed often stimulates the economy by dropping interest rates, which sends bond yields plummeting and bond prices up sharply. 

Point #3 is important. The negative correlation of Treasuries was prevalent during the falling interest rate environment of the previous decade but tends to fade during times of rising interest rates or high inflation. This occurred during the 1970s, 2018 and now again in 2022. 

Hence, investors in a traditional 60/40 portfolio who relied on their Treasury allocations for protection were not able to realize that benefit. Bonds fell in tandem with stocks, leaving investors nothing to keep their portfolios in the green or rebalance into equities with. 

What can Investors do to Protect Their Portfolios?

For younger investors, staying the course and doing nothing is always an option. Interest rates can normalize over time. Investors with a long-term horizon can stick to their asset allocation plan and ride out current volatility. This approach requires strong discipline and a high risk tolerance. 

Other investors can consider high volatility assets with a lower or negative correlation to stocks and bonds. Traditionally, this meant a broad basket of commodities, such as oil, wheat, soybeans, gold, silver and copper. The downside of this approach is high fees, high volatility, contango for futures-based instruments and the lack of a positive expected return over time. 

An allocation to short-term Treasuries that have lower durations can also work. The prices of these bonds would be expected to lose less as interest rates rose. However, the yield is also lower and if rates dropped, the prices would shoot up less, making short-term Treasuries less effective as a hedge during a market crash. 

Investors can also consider holding cash in the form of ultra-short-duration money market instruments. These include certificates of deposit (CDs) and zero to three-month Treasury Bills (T-Bills). These assets have extremely short durations, effectively immunizing them from interest rate risk. However, the yield for these assets is low, and inflation can quickly erode their purchasing power. 

Finally, investors can consider actively hedging the equity allocation in their portfolios with derivatives like VIX futures and put options on broad market indexes. This approach is highly technical and requires advanced knowledge. Risks include high costs, decay over time and unexpected volatility. Pulling off this strategy also requires a bit of market timing, which is ill-advised for most investors. 

The Final Word on Bonds and Portfolio Management

The current macroeconomic environment might be unfavorable for bonds, but that won’t always be the case, especially if interest rates fall in the future. For most investors, an allocation to high-quality, investment-grade bonds in line with their investment objectives and risk tolerance remains a good idea. Duration should be matched to the time horizon to mitigate interest rate risk. For those concerned about diversifying their portfolio’s protection further, a tactical allocation to commodities or money market instruments to reduce interest rate risk and volatility could be a sensible strategy.