3 bond questions that are top of mind for advised clients
Market volatility can make your financial future feel uncertain, test your resolve, and even cause you to make impulsive decisions. Add on a less common market event like we saw this past quarter—with bonds performing worse than stocks—and you may find yourself questioning your investing strategy and the role of bonds as ballast in your portfolio. For those further along in your retirement, you may also be concerned that time isn’t on your side.
History has shown that markets are resilient, and staying the course is often the most effective long-term investing strategy. Before considering changes to your financial plan, we’re here to answer 3 important bond questions and provide insights to help all investors feel more in control of their finances.
Your advisor is here to support you through market volatility, discuss your concerns, and equip you with meaningful insights to help you stay on the path that’s right for you.
1. Are bonds no longer working to balance my equity risk?
The way bonds work is the same today as it’s been for decades. A bond continues to serve as a loan that the borrower agrees to repay at a stated interest rate by a specified date, or maturity. While nothing has changed structurally, it’s only natural to be concerned about their recent performance.
At the end of the first quarter of 2022, Vanguard Total Stock Market ETF (VTI) was down 5.37% while Vanguard Total Bond Market ETF (BND) was down 5.85%, ranking as the third-worst quarter for bonds in the last 50 years.* Having a well-balanced portfolio doesn’t protect you from losses all the time, but it’s proven to play a valuable role in reducing volatility over the long run. In fact, despite their recent decline, bonds have provided a reliable balance to equity risk over the last 20+ years.
Despite a historically bad quarter, with a nearly 6% loss for Q1, bonds still only lost a fraction of what stocks lost from January 3 to March 14, 2022. And we have no reason to believe that they won’t continue to play an integral role in helping moderate volatility in your portfolio going forward.
Bond returns provide balance in past stock market corrections: 2000–present
Note: Stock performance is measured by Vanguard Total Stock Market Index Fund Investor Shares; bond performance is measured by Vanguard Total Bond Market Index Fund Investor Shares. The 2022 correction is based on the March 14, 2022, low point since peaking in January 2022 and isn’t intended to state a firm low point of this market cycle.
During periods of uncertainty, it’s important to revisit the basics and remember the strategic importance of your asset allocation. When you invest in bonds, you’re generally taking on less risk than stocks in exchange for lower returns. You’ll also receive more interest than you’d typically earn from a money market fund. But unlike a money market fund, the value of your bonds will go down as interest rates rise and vice versa. When yields rise, you’ll receive more interest income from your bonds, which can help to offset your overall losses.
Your portfolio was created to align with your goals and risk tolerance and was built to help keep up with inflation and volatility, factoring in 10,000 market scenarios across a range of economic and market possibilities.
2. Are bonds a poor investment when interest rates are rising?
When interest rates are on the rise, keep these 2 important considerations in mind.
First, it’s important to understand how the federal funds rate (FFR) impacts bond yields and prices. The FFR sets short-term interest rates, while longer-term yields such as those of the Total Bond Market ETF are influenced by the expected trajectory of the FFR, inflation expectations, and other economic factors.
The inverse relationship between yields and bond prices can make it seem as though bonds are easier to time than stocks—but that’s not the case. Like stock markets, bond markets are forward-looking and often price in new information much faster than can be anticipated.
For example, in the past 3 full rate hike cycles that occurred in 1999, 2004, and 2015, high-quality bonds saw subdued returns in the 12 months leading up to the rate hike. Then, in the 12 months thereafter, rates accelerated and the rate hike cycle ended with overall positive returns.
Trailing and following bond returns from start of rate increase cycle
Source: Chart shows the total returns for the Bloomberg US Aggregate Bond Index in the 12 months before the Federal Reserve’s first rate hike, in the 12 months after the first rate hike, and from the first rate hike to the last rate hike for cycles effective June 30, 1999, June 30, 2004, and December 17, 2015. The June 30, 1999, dates include 12 months before (July 1, 1998–June 30, 1999), 12 months after (July 1, 1999–June 30, 2000), and first to last rate hike (July 1, 1999–May 16, 2000). The June 30, 2004, dates include 12 months before (July 1, 2003–June 30, 2004), 12 months after (July 1, 2004–June 30, 2005), and first to last rate hike (July 1, 2004–June 29, 2006). The December 17, 2015, dates include 12 months before (December 18, 2014–December 17, 2015), 12 months after (December 18, 2015–December 16, 2016), and first to last rate hike (December 18, 2015–December 20, 2018).
Let’s take a look at what’s happening now. On March 17, the Federal Reserve raised the discount rate one-quarter of a percent, to a range of 0.25% to 0.50%, and signaled that it expects to lift rates up to 6 more times this year. In response, some investors believe they should move to cash and buy back bonds after the Fed rate hikes are complete. But as history has shown us, you may not need to wait until the end of the rate hike cycle to benefit from positive returns. In fact, if you wait until the Fed is done raising rates, bonds will likely have partially or even fully recovered and you’ll risk locking in any losses.
Second, when it comes to managing interest rate risk, it’s important to understand how a bond fund’s duration and your investing time horizon factor into the equation. A common best practice is to make sure your time horizon exceeds the duration of your bond funds. Doing so will allow the pain of potential bond price declines to be offset by future yields. This strategy coupled with prudent rebalancing can help you take advantage of rising rates over time.
3. Should I move from bonds to cash?
When markets are volatile, moving to cash may sound like an appealing option. But we believe bonds will continue to play a valuable role in reducing overall portfolio volatility and investors who stay the course will typically come out ahead of those who move to the sidelines. In fact, those who held steady through recent downturns are now earning yields that are twice what they were last year.
Staying the course is naturally easier for younger investors and early retirees, but if you’re further along in retirement, it may be more difficult. What if you don’t have 1 to 5 years to wait for your portfolio to recover? It can be hard to watch your portfolio lose value, especially if you’re living off your retirement income and are worried you might not see your bottom line recover during your lifetime.
If you’re in this situation, consider these important questions:
- Have your retirement income needs changed?
- Will you still have more than enough resources to support your needs throughout your lifetime? Oftentimes, the answer is yes. In those cases, we recommend staying invested to allow your portfolio to recover. If the answer is no, we’ll discuss what changes are needed to help you get back on course. Taking small steps, like adjusting your spending, can make a big difference.
- Are you comfortable locking in losses even though you may not financially need to? Or perhaps you’re letting the shock of your financial statement lead you in a direction that’s not necessary based on your financial outlook.
The months ahead might continue to prove challenging for stocks and bonds alike but remember that any change in your strategy is far from a sure thing. And hindsight is always 20/20. We believe the best approach for most investors is to stay the course with a low-cost, well-diversified portfolio aimed at long-term appreciation and stability.
Your advisor factors the markets and economy into your plan and retirement success rate. They rebalance to ensure you stay aligned to your asset allocation, identify tax efficiencies, and help you weigh your options during good and bad times. When markets are down, they’ll help guide you to the right course of action so you don’t end up making impulsive decisions you may regret later.
*Vanguard calculations are based on data from Morningstar, Inc., as of March 28, 2022.
All investing is subject to risk, including the possible loss of the money you invest.
The performance data shown represent past performance, which is not a guarantee of future results. Investment returns and principal value will fluctuate, so that investors' shares, when sold, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data cited. You can view Vanguard Total Stock Market ETF (VTI) and Vanguard Total Bond Market ETF (BND) current month-end-performance data and standardized performance (1-, 5-, and 10-year returns) and expense ratio information.
Past performance is no guarantee of future returns. The performance of an index is not representative of any particular investment, as you cannot invest directly in an index.
Diversification does not ensure a profit or protect against a loss.
Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.
For more information about Vanguard mutual funds and ETFs, visit Vanguard mutual fund prospectuses or Vanguard ETF prospectuses to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.