What Happened to Bonds?

Mark Meredith, CFP®

The start of this decade has been a bloodbath for bond investors, unlike anything experienced in the prior 90+ years. Below we have a chart of the Bloomberg US Aggregate Bond Index dating back to 1976, plotting the annual index returns via the gray bars and the largest intra-year declines shown by the red dots.

As you notice on the right hand side of the chart, the bond index was down 17% at one point last year. To make matters worse, inflation ran hot at 6.45% for the year and was over 7% in 2021.

If we were to simply gauge the bond market's performance over the last 3 years covering 7/2020 - 06/2023, the Vanguard Total Bond Market Index (VBTLX, which tracks the Bloomberg US Aggregate Float Adjusted Index) has produced a cumulative inflation adjusted return of -25.3% (Source). During the exact same period, the Vanguard US Total Stock Market Index (VTSAX) produced a cumulative inflation adjusted return of over 24% (Source).

Looking at other areas of the bond market, long-term government bonds returned -26.1% in 2022. I have pulled some data from DFA's Matrix Book of Investment Returns (if you would like a copy please let us know) to put this in perspective, and from 1926 – 2021 the worst calendar year return we saw for long-term government bonds was -14.9% in 2009. If you are younger than 97 years old, I am confident this is the worst bond market you've ever seen.

What is going on? Bonds are supposed to be safer than stocks right? Why are stocks continuing to progress forward while there seems to be no end in sight for the bond destruction? Why should someone continue holding bonds when they can now buy CDs or Money Market Funds paying greater than 5%?

What Happened, A Chain of Events

We’ll try and sum this up through a series of events that happened over the last few years:

  • Covid entered the United States.
  • Most economic activity was halted to try and stop the spread.
  • This led to temporary unemployment numbers like we've never seen.
  • The US Government provided massive fiscal stimulus via PPP, enhanced unemployment benefits, paused student loans, direct payments to individuals, eviction moratoriums, SBA loans, mortgage forbearance etc. etc.
  • This created inflation as we had too many dollars chasing too few goods and services being produced.
  • The Federal Reserve was slow to tighten monetary policy suggesting inflation was transitory.
  • When the Fed started to act, they acted in an aggressive manner by raising interest rates faster and higher than the market originally suspected.
  • These unanticipated rate increases significantly affected bond prices to the negative.

Why Does a Bond Price Change?

It's always good to get a refresher on that last bullet point above. What makes a bond's price change? With stock prices there are seemingly endless variables that cause the price to change minute by minute. Bonds are more straightforward.

Imagine Sally buys a $1,000 bond that pays 5% for 5 years and at the end of 5 years she will receive her $1,000 of principal back. She looks forward to receiving $50 in interest every year so she can pay ordinary income taxes on the interest and spend the remainder on a loaf of bread at Aldi.

The day after she buys the bond, the issuer is now offering 6% bonds to new purchasers. Sally thinks she will sell her bond and go buy a new 6% bond, so she can now afford the keto friendly bread. Reasonable right?

There is a problem, no one wants Sally’s 5% bond because they can go buy a 6% bond themselves. She realizes the only way she can sell her bond is if she discounts the price down to the point where the buyer would get a 6% annual return, which would be approximately $958. The buyer would still get the $50 per year in interest paid on the bond, but now they receive the price appreciation from the $958 they paid to the $1,000 that it will mature at in the future, which gets them an additional 1% per year.

Sally decides there is no free lunch to be had in selling her bond, and she will have to continue with her carb filled bread.

Bond Returns Are Predictable

How can I suggest bond returns are predictable when I just stated earlier in this post that the bond market got it wrong? Further, I've been pretty consistent over the years that no one can predict anything with accuracy, so have I now gone crazy all of a sudden (no jokes please)?.

In the short run, anything can happen. There is even the longshot scenario we pull a Weimar Republic and see 700% inflation, but not likely. In the long run, as long as your bond issuer does not default you will receive 100% of your interest during the bond term and 100% of your principal at maturity. That is a certainty. Barring defaults and assuming you hold until maturity, you will not lose money in bonds unless you buy one with a negative interest rate (hello Europeans reading this!).

If you buy a Treasury bond at auction that is a 5-year maturity at 5% interest, that's exactly what you will get if you hold until maturity, assuming the Treasury does not default on their debt. The same goes with corporate bonds, but there is a higher chance of defaults in the corporate bond market which is why they tend to pay higher interest rates than Treasuries.

What About Bond Funds?

Some will argue the paragraph above is only true for individual bonds, not bond mutual funds or ETFs.

There is a common, and highly misguided, belief that individual bonds are somehow safer than bond funds. Cliff Asness, CIO of AQR Capital Management, sums this up beautifully in his 2014 article “My Top 10 Pet Peeves” (number 10):

“Bond funds are just portfolios of bonds marked to market every day. How can they be worse than the sum of what they own? The option to hold a bond to maturity and “get your money back” (let’s assume no default risk, you know, like we used to assume for US government bonds) is, apparently, greatly valued by many but is in reality valueless. The day interest rates go up, individual bonds fall in value just like the bond fund. By holding the bonds to maturity, you will indeed get your principal back, but in an environment with higher interest rates and inflation, those same nominal dollars will be worth less.”

A great predictor on your future return from a bond fund is your starting yield. While bond funds may list several different yields, one may want to look at the bond fund’s estimated yield to maturity or the fund's SEC yield to get a gauge on this.

Ben Carlson, author of the Wealth of Common Sense blog, showed in a 2022 post that there is a great relationship between one’s starting yield and their future 5 Year Returns:

With the help of Dimensional Fund Advisors I have been able to pull some historical data on one of the bond fund's we commonly recommend at Meredith Wealth Planning, the Dimensional Investment Grade Portfolio (DFAPX).

On 12/31/2011 the fund had an estimated yield to maturity (YTM) of 2.62% and the duration of the underlying holdings was between 5-6 years. From 01/01/2012 - 12/31/2017 the fund earned 2.66% annualized, falling very close to the fund's estimated yield to maturity from the start of the holding period. If you buy a bond fund with a 1% YTM, that's about what you should expect going forward.

Other times it will not look so pretty, especially if rates rise drastically at the end of your holding period.

As of 06/30/2023 the fund had an estimated YTM of 4.97%, which would be a fair number to use in planning purposes for expected returns from the fund.

If you are an investor in a fund like this and you bought it previously with a much lower YTM, you should be loving it at today's yield. At the end of 2020 the fund had a YTM of 1.11% with trailing 12-month inflation of 1.23%. With the YTM at the end of June standing at 4.97% and trailing 12 month inflation at 3%, things look better from this point forward for bond investors today. No one enjoys the ride it took to get here though.

Disclosures: This article is for informational purposes only and should not be considered a recommendation. Information contained in this article is obtained from third party resources that Meredith Wealth Planning deems to be reliable. Consult with a financial advisor before implementing any strategies. Past performance does not equal future results. Meredith Wealth Planning does not guarantee any minimum level of investment performance or the success of any index portfolio, index, mutual fund or investment strategy.

Don't go through retirement alone.

Step 1) 30 Minute Consultation

A quick chat to get to know each other and learn more about what you're looking for in an advisor

Step 2) Think About It

We know that working with an advisor is a big decision, take some time & sleep on it

Step 3) Recommendations, Strategy, & Implementation

When you're ready, we get started with our planning process

Talk with a retirement partner today
A no-pressure, 30-minute conversation to see if we're the right fit for you
Schedule Your Free Consultation