Thoughts on Bonds in 2022
Bonds in 2022 are a mystery. Before we talk about my dividends for March, I want to chat about bonds, an asset that represents 7.5% of my investments.
It’s somewhat clear that things are changing in the world of rates. People often point to the 1970s as an example that bonds can succeed in a rising rate and inflationary environment. Defining success is hard in that time period. Yes, short term bonds did have a 1% real return between 1966 and 1982 but long term bonds lost 4.5% per year while the S&P basically stayed flat adjusted for inflation.
In simple terms, if that’s success then we’re all boned if we see a repeat of that type of market and those in long term bonds are boned the most.
The obvious question is whether the years around the 1970s a good proxy of anything anymore. After all, while inflation was high like it is today, the 70s actually had an average federal funds rate of 7.15% and a 10 year treasury rate that started the decade at 7.35% and peaked at 13.9% in the early 80s.
That’s certainly different that what we find ourselves in today. After all, the fed funds rate still sits near 0% and the 10 year treasury just SOARED to 2.9% against an inflation measure that’s nearing 9%. Naturally, our inflation isn’t a long term problem yet but what happens if it becomes that?
Enter the questions around bonds, our normally safe friend, and what the hell is going to happen to these guys in 2022 and going forward. In my mind, bonds in 2022 have a bit of a problem.
Low starting yields in the 1-3% range depending on duration means terrible real returns against today’s inflation. This could be a short term problem but if said inflation continues then the fed will have no other choice than to keep raising rates.
We’ve already seen the market react to that expectation in the form of the 10 year treasury which has moved back to 2018 highs from a low of 1.5% this time last year but that number is still relatively low when you consider inflation which makes me think that the market isn’t expecting this to be a long term problem just yet.
For those not familiar with bonds, there is a correlation with bond prices and corresponding yields. It’s well known that when interest rates rise, prices fall and vice versa. We already saw the inverse of that with prices rising as rates fell during the pandemic and now the reverse is happening. As yields rise, prices are falling.
Bond sensitivity(also known as how much prices fall or rise) is measured by the bond’s duration.
The idea is simple. Let’s say you buy a $100 with a 1% yield today and tomorrow yields rise to 2%. Naturally if you buy a $100 bond tomorrow, you can get a 2% yield so the bond you bought today is now going to be worth less since it has to compete with the new yield structure.
If you’re buying and holding to maturity then price might not matter much as you’re really going for yield but these days since most people invest in bonds via ETFs or mutual funds, price has an impact on overall return and rising rates are not good for prices. That’s to ignore the fact that low yields are a problem too.
In changing rate scenarios, the duration of the bonds you hold will impact prices positively and negatively depending on what happens to rates. A good rule of thumb is that for every 1% rise in rates, a bond will rise or fall in the opposite direction based on it’s duration. With ETFs and mutual funds, there might be wider swings as investor sentiment can play a part as well.
For example, a 1% rise in rates will cause a bond with a duration of 6 years to fall 6% while a bond with a duration of 20 years will fall 20%. This is not going to be perfect for every fund given underlying holdings but it’s close enough for government work.
Given that example, you can see why long term bonds do poorly during an extended period of rising rates like we had in the 70s and why short term bonds do less poorly.
So what does this mean for Bonds in 2022?
Well some of this is already priced in as the expectations of rising rates have been priced into the 5-10-30 year treasuries. There’s a reason the yields have moved ~150bps with a 25bps change in the fed funds rate and why mortgage rates are back to 5%+. Inflation and expectations of more rate hikes are starting to get priced into the equation.
That’s why the price of the Vanguard total bond fund ETF, an ETF with an average duration of about 7 years is down 10.1% in the past year. Vanguard’s long-term bond ETF with a duration closer to 15 years is down 16% and the short-term bond ETF which has a duration near 3 years is down 6%.
It’s not a pretty picture for investors who were buying bonds more recently as those are pretty significant short term losses. It can certainly spook those who expected bonds to be the boring steady alternative to risky stocks.
However, a couple things are still true. One must remember those are only price reductions and overall returns are slightly better given that each of these bonds pays a yield that reduces the overall loss. It’s true that yields these days are paltry so a 20% drop with a 3% yield is still pretty bad which is clearly a bit different than the 7%+ yields we had in the 70s.
On top of that, it’s also important to scroll out and look at the bigger pictures as most of these prices are only back to 2018-2019 levels given the recent spike. That’s due to the fact that rates receded very recently during the pandemic. Given the yields investors received during that time frame, most bond funds are still positive in that time frame.
It’s just that now that yields are trending up again, prices are resetting back to what they were when rates were higher.
Plus, bonds still have history on their side. History might not be reflective of today’s very low rate conditions but an allocation to bonds has generally smoothed out losses in the long run especially during market corrections as seen in 2000/2008 and the recent pandemic crash. Recent performance isn’t great but who has a crystal ball to see what happens going forward.
In reality, what’s happened recently to bonds feels like an aberration but that’s still not what you want to see from bonds. Given today’s market dynamics, it’s not crazy to see these larger moves even if they are surprising to some and it may have caught certain investors who thought of bonds as a safe haven unaware.
That’s because one problem still remains and it’s a big one. INFLATION! Even at today’s prices, buyers and holders of bonds are receiving 2-3.5% yield which leads to negative real yields. Even investing in higher yield and riskier bonds leads to negative real yields, add rising rates and prices are starting to reflect that reality and leading to some really bad returns for bonds in the short-term.
Interest in bonds is waning which may mean prices move more than the underlying duration would suggest they might. Investors don’t like uncertainty and while it’s a feature of stocks, it isn’t meant to be a feature of bonds and prices may be reflecting that.
The natural risk going forward is inflation not being temporary and a necessary rise in rates to combat it. That’s obviously not a good thing as shown by historical returns during rising rates but what’s an investor to do?
I personally things bonds don’t represent a good risk/reward right now. Yields are low which limits return and the likelihood of rates going lower isn’t very high given inflation. However, that’s not to say other alternatives look much better. Rising yields will eventually make bonds look interesting and should in theory also re-price stocks which have been highly valued for the same reason bond prices soared, low rates.
Sitting in cash is a problem too since inflation eats away although certain crypto products do offer some yield as do certain inflation protected bonds.
I can’t speak to everyone but for me, I’m not doing much and that’s for three reasons. One is that I don’t have a huge allocation to bonds so my risk of being wrong is low. If rates rise and prices drop, the impact isn’t huge and I have a long-term time frame to wait for recovery.
Two is that I see bonds as a risk off alternative to stocks in the sense that when one goes down, the other doesn’t go down as much. That may seem wrong based on the near 20% moves I talked about above but it’s the reason why I invest mainly in low duration bonds. While this means I give up some yield which isn’t great in a high inflation environment, it also means that as rates rise, my yields catch up faster and prices are impacted less. In an environment like the past few years, where the fed funds rate was 0, many people chased the higher yields offered by long term bonds(and were rewarded with short term price appreciation) but those people also being punished now.
I was ok sitting in short-term bonds that didn’t offer much in terms of yield simply because I want that money there to smooth out the risky returns of stocks. It’s been a while since I’ve bought bonds so the recent correction hasn’t impacted me much especially as stocks have corrected more and I’ve been pumping money into those assets.
And three I have a good portion of my bonds in I-Bonds which have no price risk since I plan to hold them to maturity(or at least 5 years to not incur penalties) but also have a variable yield that tries to track inflation. I-Bonds are now paying 8-9% with inflation being where it is and are by far the best risk off asset you can find in today’s market. The only minus is that they have a $10,000/year maximum but are a good alternative to cash at the moment if you don’t need the money for at least 12 months(since you can’t take money out for 12 months and have to pay a 3 month interest penalty after that until you hold it for 5 years).
I’ve always viewed bonds as assets that are riskier long term than stocks but much less risky in the short-term but I’m not sure if Bonds in 2022 reflect that mantra. Inflation, rising rates and an everything bubble certainly don’t make any decisions to flee bonds easy which is why I’m staying put. It makes it easier that I’m in short-term bonds but this is exactly one of the reasons those are part of my asset allocation. Long-term bonds are too risky for an asset that I want to be risk off.
An important aspect of this is that prices and rates are forward looking. While the fed funds rate has only moved 25bps, the treasury rate and mortgage rates have moved multiples of that which is reflect in the prices of those bond ETFs. Given that the 10 and 30 year rates are still shy of 3%, it seems like the market isn’t pricing in long term inflation but if that changes or if the fed doesn’t raise rates as much, things could change quickly.
As always timing the market is hard which is another reason to not do anything. For all we know, inflation could disappear soon, the economy could move into a recession and the rate could drop sending prices up again.
Now that we’re through my bond diatribe, let’s talk about my dividends in March. This is usually a solid month due to all of my index funds and ETFs paying out.
Last March, I sat at $2597.50 so let’s see where I am today.
March 2022 Dividends
March’s dividends came in at $2629.46, a 1.2% bump over last year.
It’s a small bump but hey, growth is growth. These bigger months are never going to grow as fast on a percentage basis as some of my smaller months since the start point is so much higher. For the year, I’m up 4.9% over this time last year.
That money re-invested will push my forward income up by $76 annually. It’s not a huge amount but compounding is a big part of the game and will help all these numbers going forward.
On top of the dividends, there was also a $581.99 long term capital gain from one of my mutual funds and a $22.34 short term capital gain. It seems like these have been more common lately despite the fact that a lot of my money sits in index funds. It seems like re-shifting within indexes created a bunch of capital gains that had to be passed on to the investors. The good thing is that all of these so far have been in tax-advantaged accounts so no tax bill for me.
Since we’re talking about bonds, my bond payments account for about $130 of this total so clearly a small percentage but since they pay monthly, they play a bigger role in my other months. Rising yields should help that grow faster as well even if prices drop in the short term. Speaking of small additions, my M1 accounts totaled $118 this month, up 16% over last year.
That portfolio is growing slowly but becoming a bigger portion of the overall pie. I think I’ll have more opportunities to put money into that account this year. There’s certainly some market volatility in both stocks and bonds that should help yield seekers who are buying today.
I’m not a dividend investor but find it pretty fun to track all this stuff. My dividend employee Steve, earned a solid $15.78/hr. and while he needs to step it up to keep up with inflation, I’m happy to get above that magic $15/hr. mark in any month.
For the year, good ol’ Steve sits at an hourly wage of $6.62 so not quite enough to retire just yet.
You can see in the below graph that Steve’s best months are ahead and I’ll keep pumping money into the accounts to try to grow his salary.
There’s a few small months ahead but then we’ve got June to look forward to in a few. It, along with September and especially December are big drivers of overall results.
However, given my M1 accounts, I’ve also started to see bigger months in the off months as well and am hopeful to see those grow quickly through the next few years. It’d be nice to have all these months above $1,000 in a few years and while I’m far from there right now, I think I could hit that mark in a few years, maybe 2025 at this pace.
Overall, it’s been an interesting couple of months to be an investor. Inflation is up, stocks, crypto and bonds are all down and it is hard to find a safe haven for money that’s quickly losing value. I guess that’s why house values have shot up so much as people look at inflation hedges in that area. I’m glad we bought about 18 months ago because we’d probably have to pay quite a bit more than we did then with a rate that’s 250bps higher. That’s not a good sign for house buyers today and I wouldn’t be surprised if home sales slow down too.
It’s all doom and gloom for the economy but maybe we’re all wrong and things will be great! I often find that the best time to buy is when others are sour on things and while things are certainly not the worst they’ve ever been, there have been a lot more negative voices than in recent memory. It’s easy to see why as the silver bullet that was the Fed lowering rates likely won’t be coming anytime soon which might squeeze all asset classes.
It’s a mad world out there but there’s not much else to do but invest, tune out the noise and keep trudging along. Manage risk as best as we can, enjoy life and the ride it gives us and see what happens.