More Carnage in the Bond Market - but the Math Doesn't Change

More Carnage in the Bond Market - but the Math Doesn't Change

October 26, 2023

For anyone looking at statements lately, it has been painful as not only have stocks and real estate struggled, but the last few months intermediate to long-term bonds and bond funds have also had sizable losses.  But bonds have one BIG difference as compared to stocks and bonds: their future returns can be calculated (assuming no default) based on the interest rate and final maturity value.  Again - what's happened to bonds the last few years is that older bonds that were paying higher rates like 4,5,6% or more were trading in early 2022 for substantially above their $1000 maturity values because their rates were much better than newly issued bonds.  But as rates rose in 2022, those bonds went from trading above $1000 to trading below $1000 as new bonds suddenly WERE paying more than their older counterparts.  As interest rates settled down from late 2022 into early 2023, the drops stopped and returns were positive based on the interest received.  But recently, interest rates have moved up substantially again, pushing bond prices down further.  Many high-quality, intermediate-term (5-10 year maturity) bonds have seen prices go from over $1100 to under $900.  But here's where the math comes in - every one of those bonds is still set to mature at some future date for $1000.  The bond price has moved down so that the return from THIS POINT to maturity is higher to be in line with current return demands.  (If you can buy a CD for 5.5%, you want a non-government guaranteed bond to pay at least 6-7% - you get this by paying less for the bond.)  Every day that goes past means we are closer to the maturity value of $1000, and we know that is higher than the current price.  The journey there may have more ups and downs - but eventually that bond matures for $1000 (again - barring default).  It is tempting to say I don't want any more chance of loss and just take short-term CD's or money markets - but in my professional opinion, this is a poor decision for money that isn't needed in the near-term because of a few reasons:  1. If interest rates decrease, the rates on money markets and CD's will also fall - so you won't make current rates year after year.  2. We are buying bonds at below maturity value - so we have a rising tide over time, 3. Study after study shows longer-term bonds return more than money markets/CD's in the years after the Fed stops raising interest rates.  

There are no guarantees because we don't know what defaults may be (but this is generally minimal on high quality "investment grade" bonds), but the math of potential future bond returns has not been even close to this good since before the financial crisis of 2008.  I choose not to buy individual bonds but use bond mutual funds for diversification of risk as well as research on that default risk and so we don't have specific maturity dates - but every fund I use we can see what their average maturities are and give a pretty good approximation of what their returns may be over that period of time.  And believe it or not - while rising interest rates hurt the statement values in the short-term - it is actually a positive long-term because we still know all bonds will mature for $1000, and higher rates means that the interest we receive along the way can be reinvested at the higher rates.

Stocks and real estate are still core long-term investments - but only bonds have calculable returns over time - and these calculations look great right now.  Looking at a bond funds' recent returns may be ugly - but looking under the cover, the math says it is a great time to invest.  I certainly expect positive returns in the next 6-12 months, but this still has uncertainly due to interest rates.  However, I am as confident as ever that the returns on our core bond funds over 3-5 years will make up for the recent pain.