Why You Shouldn’t Abandon Bonds

The source for this article provided by Vanguard - Vanguard Perspective Series, 2022.

Bond Prices May Not Matter as Much as You Might Think They Do 

While swift bond price declines can be upsetting, it’s important to remain focused on the long-term benefits of higher interest rates. Bond total returns have two main components: price return and return from income. 

Changes to interest rates cause these two components to move in opposite directions. 

As a medium- to long-term investor, you should care more about bond total returns instead of the negative short-term impact on bond prices. In fact, as we show in the chart, the long-term performance of bond investments has come mostly from income return, not price return.

Why Bond Bear Markets are Fundamentally Different From Stock Bear Markets 

For bond investors, the price return component’s effect on total return decreases as time extends. For stock investors, the price return component of total return is much more significant. “The Lost Decade” is a great example of this: From January 2000 through December 2009, the total annualized return for the S&P 500 was –0.95%, inclusive of the reinvestment of dividends. The negative price returns caused by the bear markets of 2000–2002 and 2007–2009 had an immense impact on long-term returns. 

Now take the bond bear market of the 1970s, which was a terrible time to have been invested in bonds as both inflation and interest rates were soaring. But consider this: Long-term bond investors who reinvested their income, and remained patient as compounding took hold, nearly doubled their capital from 1976–1983. Over the longer term, bond total returns are driven much more by reinvestment of interest income and compounding than by price returns. So try to look beyond the immediate pain of any losses appearing in your quarterly bond portfolio statements and instead focus on the longer-term upside of rising interest rates.

Interest Income And Reinvestment Make up the Largest Portion of Total Return in Bond Funds

Bond Math Holds up Even During Fixed Income Shocks 

Consider short-term Treasuries: interest-rate-sensitive securities whose total returns are extremely sensitive to central bank policy changes. As interest rates on the short end of the Treasury curve have risen due to expectations of further Federal Reserve policy adjustments, so too has the weighted average yield to maturity for funds that invest in these securities. That provides a better foundation to help you weather further rate shocks, as starting yields are now much higher. Even if rates were to rise an additional 200 basis points (bps) from here,because of expectations you would now recoup any lost principal within a year and then benefit from higher yields moving forward—ultimately increasing the long-term value of your bond portfolios (see chart). 

That means the time to recoup your capital from an interest rate shock depends on your starting yield. A 200 bp rate shock from a 50 bp starting yield will take longer to break even when compared to a 200 bp rate shock from a 250 bp starting yield. 

The bottom line—as rates move higher, bonds are more attractive, not less.

Why asset allocation is so important 

While we just reviewed some important considerations with your fixed income portfolio, it is still critical to note that your overall asset allocation is by far the biggest driver of your long-term return. Understanding the nuance within a piece of your portfolio (like fixed income) is helpful, but it does not answer the foundational question of what your overall allocation should be. We believe that answering this question as part of comprehensive financial planning is a key step in actualizing your financial roadmap.