Funds

Bond funds have never looked so bad

Imagine the following scenario: A husband and wife sit down with their financial adviser for a regular review meeting.

The discussion includes a summary of recent performance, during which the adviser informs the couple that they have lost nearly 15% year-to-date. Gritting their teeth, the clients then ask, “What about the performance of our bonds?” To which their adviser replies, “That is the performance of your bonds.”

For millions of investors, this conversation has already taken place. Millions more are in for a rude awakening when they take a closer look at the numbers. Year-to-date through Monday, the S&P U.S. Aggregate Bond Index, meant to approximate the investment-grade U.S. bond universe, has lost 15%. If we add high-yield bonds into the calculation, the losses swell even larger.

The only other time investment-grade U.S. bonds fell anywhere near this much peak-to-trough was 1979-80 when the index declined almost 13% over a six-month period. Simply put, bond funds have never had a year this bad.

The S&P 500 has lost 19% year-to-date through Monday and given us the most “down days” of 1% or more since 2009. If you compare the year-to-date charts of U.S. stocks vs. U.S. bonds, you’ll notice the difference in volatility. Still, they end up in a similar place.

Despite all the emphasis on owning a diversified investment portfolio, stocks and bonds have been extraordinarily correlated in 2022. How unusual is this? Bonds were positive the last eight times in which the S&P 500 had a negative year.

The reason bond funds have struggled so much has everything to do with the speed at which interest rates have increased. In early November, the Federal Reserve implemented its fourth straight 0.75% rate increase in a concerted effort to subdue high inflation.

Never before has our nation’s central bank raised interest rates so aggressively, so quickly. As most investors know, bond prices go down when rates go up. Think of it this way: If you bought bonds one year ago that paid a 2% annual coupon and new bonds issued today offer a 5% coupon, then your bonds are less attractive. The price of your 2% bonds, therefore, goes down.

The market adjustment you see in the price of the 2% bonds is what’s known as “interest rate risk.” Unfortunately, it’s a risk that has been ignored by far too many investors for decades while rates steadily declined.

Investors whose safe money is invested in individual bonds have been more insulated, relatively speaking, from the strongest of these bond headwinds. Unlike bond funds, individual bonds can be held until maturity when the full principal is then repaid.

Our Marks Group corporate bond ladders, which are higher quality and shorter duration than the index, have lost considerably less year-to-date.

If you’re in search of silver linings, bond yields are at their highest point in 12 years. A seven-year ladder of high-quality corporate bonds yields better than 5% annualized. Even 12-month U.S. Treasurys, with their exceptionally low risk profile, yield around 4.5%.

Tax-loss harvesting strategies may also apply to fixed income this year, meaning bond funds trading at a loss could be sold to reduce tax bills, and proceeds moved into individual bonds for investors who wish to reduce interest-rate risk.

Despite the steep selloff in bond prices, investors should be careful about jumping into bond funds. If interest rates decline over the next 12 to 18 months, as the Fed’s own forecast suggests, it’s true that could boost the total return of bond funds. For most families, however, bonds are not the part of the portfolio to be adding risk.

If long-term growth is what you’re after, equities offer a more attractive opportunity and fewer strings attached.

Ben Marks is chief investment officer at Marks Group Wealth Management in Minnetonka. He can be reached at ben.marks@marksgroup.com. Brett Angel is a senior wealth adviser at the firm.

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