Are bonds still “safe?” Photo by Jametlene Reskp on Unsplash
The stock market has had a rough spell this past quarter. It’s common for stocks to experience this kind of turbulence, but the drop in bond values has surprised investors.
What’s going on here? Aren’t bonds the “safe” part of an investment portfolio?
I’d like to spend some time talking about bonds, how they work, how to think about them, and how they can affect your overall investment portfolio.
How Bond Prices Work
Most readers have at least some of their investments in a bond mutual fund or exchange traded fund (ETFs). Bond mutual funds, like stock mutual funds, are made up of thousands of different investments in lots of different companies. While stock mutual funds invest in company stocks, bond mutual funds invest in bonds issued by companies and governmental entities.
Like stocks, bonds are priced daily in the open bond market. A big driver of how bond prices go up or down is the movement of interest rates. When interest rates go down, current bond prices go up because those bonds pay more interest than new bonds will at the lower rates. When interest rates go up, current bond prices go down because the current bonds pay less interest than new bonds will at lower rates.
For the past 40 years, the Federal Reserve has been pushing interest rates lower and lower to stimulate economic growth. One of the effects of this has been a steady increase in the value of current bond holdings, like bond mutual funds.
But now we have an inflation problem. To keep soaring US inflation under control, the Federal Reserve is needing to “cool down” the US economy which it does by increasing interest rates, possibly in a very dramatic fashion. This has a result of decreasing current bond values which explains why bond mutual funds and ETFs have been decreasing in value.
Thinking Long-Term With Bonds
So will bond values ever go back up? No one knows with certainty how or when that might happen, but it’s important to remember the two components to how your bond investments grow. First, as explained above, your bond mutual funds can move up and down in value based on interest rates changes. Second, your bond mutual funds can move up and down in value by earning interest–a principal attribute of bonds.
While your bond mutual fund may be losing value due to rising interest rates, it is poised to increase in value to some extent as well. This is because all bonds have a maturity date. Once one of those bonds held in your bond mutual fund matures, the company redeems the bond and your mutual fund provider now has a chunk of money they can use to invest in new bonds at higher interest rates, resulting in a higher amount of interest coming into your investment account.
It’s also important to remember the difference between a decrease in value of an investment, and a loss. Decreases in value are “paper losses” meaning the value of your current investments has gone down. Only when those investments are sold is an actual loss realized. At Hale Financial, we always do our best to sell investments that have gone up in value rather than down to avoid real losses. At the very least, we try to only sell investments that have gone down by the smallest amount.
Potential Protections Against Bond Losses and Inflation
It should be obvious now that bonds pose some risk of loss just like stocks do. There are a few ways to protect against this, especially in the view of increasing inflation, which it appears could be around a while:
Invest in stocks - Stock investments have proven to be a good hedge against inflation while bonds have not. In this sense, stocks are kind of the “yin” to bonds’ “yang.” They can work inversely to each other over time.
Purchase real estate - Real estate has also shown to be a good inflation hedge. The beauty of real estate is also the ability to “lock in” your interest costs over time with a fixed mortgage. Even a 5% mortgage looks pretty nice if inflation rises to 7%, 8% or even higher.
Purchase I bonds - I wrote recently about the value of I bonds in an investment portfolio. These bonds are designed to protect against inflation. They’re directly issued by the US Treasury to people like you and me, so they don’t move up and down in value like bonds in the public market. Learn more about I bonds by clicking here.
I hope this is a helpful summary of bonds and how they work. Despite the recent drop in bond values, I still recommend bonds as an essential piece to every retirees’ investment portfolio. In turn, investors should consider not being too “heavy” in bonds and find other investments that can better protect against rising interest rates and inflation.