(If you are not knowledgeable about the relationship between bonds and interest rates, you will first want to read my last Letter on Understanding the Basics of Bonds .)
2018 has been an important year for the bond market as a decisive shift in the long-term direction of interest rates has taken place. After putting in a double bottom in 2013 and 2016, the 10-year U.S. Treasury Yield broke out of a downtrend on the monthly price chart that had been in place since October 1981, as shown here:
Bonds had previously been in a bull market since I was a toddler and I now have (some) gray hair. Most people reading this Letter have known nothing but an environment of progressively falling interest rates throughout their adult life. It has not always been this way. Notably, prior to this recently ended 36-year bull market in bonds, there was a 35-year bear market in bonds. The history of bonds has been marked by very long-term, multi-decade cycles.
Bonds Can Be Risky
The fact that bonds are just now beginning a new long-term bear market has significant implications for investors. As interest rates rise, bond prices fall. Many investors are now facing an environment where their more conservative investments are poised to lose them money as interest rates keep rising. This is commonly referred to as interest rate risk.
Most investors hold bonds through exchange-traded funds (ETFs) or mutual funds. Investors commonly hold bond mutual funds, such as the Vanguard Total Bond Market Index Fund, in their 401(k)s. This particular Vanguard fund is invested in almost $200 billion worth of bonds on behalf of the underlying shareholders. It currently has a yield of 3.11% and an average duration of 6.1 years. Duration measures the impact of interest rate changes on the fund. In general, for every 1% increase in interest rates, the price of the fund will fall by about 6.1%. Mutual funds have the potential to compound this loss of principal risk even further though. Let me explain.
Let us assume a reasonable scenario. U.S. economic growth continues at a strong pace for a couple more years, the global economy, led by China and Europe, rebounds, and inflation starts to heat up to the 3% to 4% range. This could easily lead to a 2% rise in longer-term interest rates over the next couple of years and the fallout would be losses for many bond fund investors. If it happens relatively quickly, a significant amount of investors could begin to make withdrawals from their bond funds, especially if a booming stock market provides an attractive outlet. This would force fund managers to have to sell bonds in order to raise enough cash to meet investors withdrawal requests. They would be selling bonds at a loss and thus not able to hold them until maturity to regain the full principal. This would result in permanent losses for bond fund holders.
The way to overcome this loss of principal risk is to buy higher quality bonds (avoid default risk) individually and hold them until maturity. Owning individual high-quality bonds until maturity essentially reduces the playing field to only one risk—opportunity cost. In this context, the opportunity cost would be earning less income than one could otherwise get from making a new investment. Let me explain.
I could go out and buy very highly rated bonds for Apple that mature in 2027 and presently yield about 3.6%. I could thus hold these bonds for about 9 years and earn an average annual return of 3.6%. However, in 2 years, under a scenario like the one I previously outlined, the price of these Apple bonds would fall and thus new investors could buy them or comparable bonds perhaps yielding 5%+. As long as I held on to the Apple bonds I would not actually lose money though (no realized losses) because the price of the bonds would slowly recover until the full principal is returned at maturity. But the key drawback—the opportunity cost—would be that I would earn less interest for the next 7 years then I otherwise may be able to earn if I was positioned differently.
The same thing can happen to an investor owning a fixed rate annuity. A stable 3% to 4% may look good now, but the holder of such an annuity could be taking an opportunity cost beating in just a few years with no way out, absent high surrender charges. History confirms this. I suspect that a 36-year bull market in bonds has created an environment of blinding complacency that hindsight will eventually paint as obvious.
Enter My Strategy
Other than variable rate bond funds, a topic for another day, owning bond funds with longer average maturities is an absolute no-go for me.
The way to overcome interest rate, loss of principal, and opportunity cost risks is to ladder a group of bonds with short-term maturities. In the current environment where long-term bond yields are barely above short-term bond yields, there is not much of a yield sacrifice for owning only short-term bonds.
To execute this strategy, an investor could buy bonds that mature in 1 year, 1 1/2 years, 2 years, 2 1/2 years, and 3 years. Each time a bond matures you then reinvest the proceeds in a new bond with a roughly 2 1/2 year maturity. This ultimately creates a short-term portfolio of bonds that constantly rotates new money into what I anticipate will be higher and higher yielding bonds. This enables the investor to keep capturing exposure to higher yielding bonds while minimizing all the other risks.
I have been executing a strategy similar to this for many of my clients with large enough portfolios. Also, by having an in-depth knowledge of certain industries, such as semiconductor capital equipment and mining, I am also able to buy bonds that have less risk than what is generally perceived by the market which typically results in higher yields for clients while still sticking to the essential “high-quality” aspect of the strategy to avoid loss of principal risk from an individual bond (default).
Most investors—some more than others—need to have a conservative component to their overall investment portfolio. This component must be an anchor of stability that produces income and acts as a ballast to the overall portfolio. Owning longer duration bond funds at the very beginning of a long-term bear market in bonds is dangerous. The risks far outweigh the rewards. A short-term, laddered portfolio of individual high-quality bonds is a sound strategy for the current environment.
Joshua Hall, ChFC
The True Vine Letter is a publication of True Vine Investments, the investment advisory business of Joshua S. Hall, ChFC, and a Registered Investment Advisor in the U.S.A. The information presented is for educational purposes only and should not be regarded as specific financial or investment advice nor a recommendation to buy or sell securities or other investments. It does not have regard to the investment objectives, financial situation, and the particular needs of any person who may read this Letter. In no way should it be construed as personalized investment advice. True Vine Investments will not be held responsible for the independent financial or investment actions taken by readers. All data presented by the author is regarded as factual, however, its accuracy is not guaranteed. Investors are encouraged to conduct their own comprehensive evaluation of financial strategies or specific investments and consult a professional before making any decisions. Positive comments made regarding this Letter should not be construed by readers to be an endorsement of Joshua Hall’s abilities to act as an investment advisor.