3 bond questions that are top of mind for advised clients

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.

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.

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.

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.