If you've properly aligned your bond strategy to your investment time horizon, don't fret about lower bond prices. Bonds mature at par.
Core bonds have had a brutal go — down nearly 14% over the last three years.
And despite staging a comeback last October, they have faltered again — down nearly 3% just in the last month. Not so appealing for the "conservative" part of our portfolio, eh?
What is the core bond index?
The Barclays Aggregate, seen above, is broadly accepted as the "core" index (meaning these types of bonds can play a foundational role in a portfolio).
Owns ~ 6,000 "quality" (unlikely to default) bonds.
Currently yields ~ 5%, meaning you should expect ~ 5% annual return.
Investors can buy a fund that mimics this index (passive investing) or buy a fund whose mandate is to try and beat it (active investing).
The most overlooked quality of a bond is its most handsome feature. It matures!
[there is an old industry joke: what's the difference between a bond and bond fund manager? One matures!).
Just like a box of cereal, bonds are static products. What's inside is consistent and predictable, but the price can change.
If I like Raisin Bran at $5/box, I'll love it at $3/box.
Lower price = better deal = higher yield.
Higher price = worse deal = lower yield.
But unlike a box of cereal — with bonds — you buy them, you "eat" (receive your coupon payments), and when the process is finished...you get your money back! That's the bond contract. No empty bowls. Bonds mature at par.
Investors must thoughtfully consider the length of these contracts. If I spend $100,000 on a bond, it matters whether I want that contract to end in 10 years or three months (both are common, but suit different investors). Current rates/yields on those maturities:
An investor can buy a 10Y bond and expect to earn ~ 4.30% annually for 10 years.
Or she can buy a 3M bond and earn ~ 5.56% annually (or ~ 1.39% for her contract length, because it matures so quickly). She then must go do something else with her money in three months. Maybe 5.56% will still be available, but maybe not.
God willing as long as bonds don't default, investors shouldn't care much what happens to their price. Bonds mature at par.
You know where you start and where you end, but the journey is uncertain.
And as we've seen in the last few years, events like inflation scares can create whacky journeys. But nothing about bond contracts has changed.
When rates/yields go up (and prices down), any coupon payments you receive during the journey can be reinvested at higher rates. So while it's frustrating to see bond prices go down, we can...
Stomach it if we don't need the money back until maturity, and
Be somewhat excited that our coupon payments get reinvested at higher yields going forward. Meaning...
Higher rates/yields, a.k.a. lower prices, aren't a bad thing if we have properly aligned our bond strategy with our time horizon.
One of the more complex ideas in finance is bond duration. The duration of the Barclays Aggregate Index is currently ~ 6, which means the average duration of all 6,000 bonds is currently ~6.
A not-technical (and incredibly helpful) definition of duration is simply, "approximately how long it will take to recoup your initial investment." For core bonds, that number ends up being very close to the average maturity.♙
Because I work with investors who are seeking clarity around their outcomes (which aids knowing when you can retire, how much you can spend, etc...), I don't work much with junk bonds. They're not bad, per se, it's just that having a reasonable chance of default doesn't provide predictability. I want my bond contracts to go through.
Investors must always hold a bond portfolio where duration is shorter than the investor's time horizon.
If you need your money back in less than six years, you wouldn't put it all in the Barclays Aggregate Index, even though it owns quality bonds with extremely low default rates. If prices go down (like recently), there may not be enough time to recoup your investment, even though the bonds aren't defaulting.
Thankfully, there are all types of bond funds to help investors manage duration. Here is a fund that owns "ultrashort" (0-3 month) bonds, meaning they mature quickly, return the principal, and then the fund buys new ultrashort bonds with that money, then those mature again quickly, etc. etc...just constantly turning over the underlying bonds.
The 5.37% yield is very similar to the 5.56% yield that we know 3M treasuries are yielding from above (so the fund is presumably doing its job), and the maturity ~ duration, which is super short because these bonds mature so quickly. Voila — that's bonds.
Let's go back to our first visual of the brutal core bond index return of -14% over the last three years, and add this fund:
The very shape of this return is shocking. How is it so clean?
Because the critical input is how quickly your bonds mature, pay you back, and allow you to reinvest — if that's ultrashort, who cares about prices? Bonds mature at par.
In fact, here, as rates/yields have gone up over the last few years, this ultrashort term fund has delivered investors a POSITIVE 4.79% return.
Bond prices down. Bond returns up. What?
We don't hear about this because we don't often talk about ultrashort bonds. But their contracts are the same as traditional bonds, everything just happens much quicker. Any negative price movement is quickly counteracted by maturity.
As long as any bond doesn't default, we don't really care about prices. What's unique to each investor is what the length of those contracts should be, and what journey we are willing to stomach.
If your time horizon is longer, let's say 15 years, you should certainly expect that the Core Bond Index will easily recover for you. Eventually. It's not as smooth as ultrashort bonds, but over time those longer bonds are maturing too, and being invested at higher rates. It all just occurs on a longer time horizon.
Expect. Expect. Expect. How would our expectation not come true?
Only treasury bonds are risk-free. If you are using corporate bonds, like those found in the Core Bond Index, it is possible (but unlikely) for those bonds to default.
But if the good Lord's willing and the creek don't rise, we won't see higher defaults in quality bonds.♘
We will get our yields. It's more likely that the real risk is...you.
That your time horizon is not currently informing your bond portfolio duration. You wouldn't be alone: this is exactly what happened to Silicon Valley Bank. The problem wasn't quality. Nothing defaulted. Just bond prices went down and there wasn't enough time to recoup the initial investments when clients started demanding their money back. Duration was too long.
The future date when you recoup your investment is way more important than the price going up or down. Bonds mature at par. The journey, from a finance perspective, is basically nothing.
But be very intentional with your portfolio duration. To enable yourself to be relatively indifferent to price, you need ample time ahead for bonds to mature. The journey, from a human perspective, is basically everything.
♙You can imagine that if you owned a 30Y bond (long-term) and it was junk quality (meaning maybe you can earn 20%/year, but with a high risk of it defaulting), then maturity ~ duration doesn't work. If it doesn't default, that bond would recoup its initial investment within a handful of years.
♘Historical Default Rates are extremely low in quality bonds.