Should You Still Hold Bonds?

Bonds are often supposed to bring stability and security to a portfolio. However, in 2022 so far, some of the even supposedly lower-risk and higher-quality bond funds have fallen by 10% or more.

Nonetheless, despite the recent run, holding bonds does still make sense for many investors. In fact, it’s the brutal adjustments that have taken place this year, that might actually start to make bonds look more interesting as investments for diversified portfolios.

A Simple Formula

Bonds are fairly straightforward. If you hold a bond to maturity they you’ll typically earn the yield on the bond. Now, there are a few other caveats around default risks, conversion and callability, but that’s basically it for standard U.S. Treasury bonds. It makes predicting bond returns for such bonds relatively straightforward.

That expected yield has risen sharply this year. Earlier this year a 1-year U.S. government bill paid almost 0%, now it pays almost 4%. For that shift to happen there was pain broadly across the bond market because higher yields typically means falling bond prices, especially for longer duration bonds.

However, we’re now at a place where many bonds are offering materially higher yields then before. Of course, you have to factor in the currently high rate of inflation in the U.S. and elsewhere, but if you have some optimism on medium-term inflation, higher yields are likely a good thing.

Comparison with Stocks

As much as bonds haven’t fared well in many cases, they have still outperformed stocks. At the time of writing, the S&P 500 is off almost 20% for the year, so losses in stocks have exceeded those in bonds, broadly speaking. Of course, that’s little comfort when both returns are negative. Still, bonds offer a degree of protection in reducing losses compared to many stocks and that’s pretty consistent with history.

Higher Inflation

The reason bond yields have risen is largely due to inflation. Bonds are often expected to earn you a return after inflation. If inflation is around 1%, it may be acceptable for a bond to pay you a fairly low interest rate.

However, with inflation now at 8% in the U.S. you need higher yields to keep up, and today, most yields aren’t keeping up. That’s in part, because the markets don’t necessarily think inflation will stay at 8% for too long, but the rise of inflation has increased the yield on bonds. In order for the yield on a bond to rise, it’s price falls. That’s what we’ve seen.

Higher Yields

Bonds are arguably now a little more attractive. Earlier this year a 10-year Treasury bond offered around 1.5%, that was less than the dividend payments on many stocks. Now that same bond offers 3.5% as the Fed aggressively hikes rates, that’s above the dividend yield on the S&P 500 (though of course bond interest payments can’t grow like dividends can) and if the Fed can bring inflation back to around 2%, that will yield a return after the effect of inflation.

Also, higher yields offer a little more protection from price swings. If a bond is paying you 4% interest and falls in price, you have a little more cushion for price falls before you lose money than with yields at 1%.

Finally, one way bonds have historically helped a bond and stock portfolio is that if the Fed starts cutting rates, then that has often helped government bond prices, especially for intermediate term bonds. Some suspect that as much as the Fed is rising rates now to fight inflation, a recession may be on the horizon. If that’s true, then the Fed may want to cut rates to stimulate growth. That could cause higher quality bonds to outperform.

What To Do

In recent years it may have made sense to avoid or limit bond exposure as yields were so meagre. However, that’s now changing. The yield on the 10-year U.S. Treasury is now back to levels we haven’t seen in well over a decade. Of course, high inflation means that the real yield on bonds is still negative currently so there’s no free lunch.

However, recent survey data does suggest that inflation is expected to decline over the coming years and if that holds it could be good news for bonds. Yes, bonds have had a tough run in 2022, but with currently higher yields, if you’re optimistic on inflation, bonds may make sense in your portfolio.

Of course, if we’re set for a prolonged run of 1970s-style inflation, or if the Fed continues to hike well into 2023, then there could well be further pain in the bond market. Currently, the market assessment is that both scenarios are less probable, but they could happen.

Historically bonds have provided some balance to stock investments and there are reasons to think that may be true in future years. The recent poor run is no reason to reject the asset class, in fact, it likely makes bonds more attractive than previously.