Let’s talk about bonds…
A simplified view of bonds…
CONVENTIONAL WISDOM:
Bonds are the ballast of an Equity/Bond (60/40) portfolio. They typically help offset equity market declines via income, capital preservation and sometimes Fed policy (lowering rates and/or QE).
REALITY:
Bonds have benefited from a 40-year declining interest rate environment. When rates were cut to historic lows, bonds further benefited from the 2008/09 monetary experiment known as Quantitative Easing by the Federal Reserve. The Fed has been supporting the bond market since 2008 by buying bonds and holding them on the their balance sheet (over $8 trillion today). In 2021/22, amidst record low yields (0.0-0.25% Fed Funds Rate), inflation spiked and bond investors sleep-walked into a wood chipper as interest rates were increased aggressively by the Fed to stem widespread inflation.
WLA’s CURRENT VIEW:
Volatility as of March 14-16, 2023 is creating profound changes in the Treasury market…5% Treasury yields were a great buy last week and remain attractive today. As rates have declined in recent days, this is not good (for future bond allocations) if bonds revert to being a low return asset class again. The Fed has created a very difficult situation (high inflation + bank stress) which makes it even more difficult to manage the direction of rates in 2023.
A quick view across fixed income markets
Treasury Bonds:
Treasuries remain attractive.strong> Short-term, 6 months to 3 years, buy them individually (not an ETF) with yields bouncing around 4-5%. Create a laddered Treasury bond portfolio. Let’s see what the Fed does with rates next week.
Corporate Investment Grade Bonds:
Investment grade spreads have been tight, that is, there is not much yield pick up over Treasuries. If there is an increase in credit risk and a recession, this will become an area to look at closely.
High Yield Corporate Bonds:
Economic and credit risk remains to be determined. I would rather focus on managing risk in the equity portfolio than add equity-type-risk to the bond portion of the portfolio.
International / Emerging Markets Bonds:
No thank you.
Be sure you understand the difference between owning a bond fund and individual bonds.
Bond Mutual Funds and Bond ETFs (bond funds) have been deeply exposed to rising rate risk in the last 12 months. A simple explanation: a fund has no maturity (it will price its NAV forever) and it must price the underlying portfolio daily.
Buying individual bonds can mitigate rising rate risk via a laddered maturity schedule and importantly, requires investor discipline to hold to maturity. Creating a laddered bond portfolio can be much more complicated than buying a fund for an individual account. However, it is not that difficult if Treasury bonds are the sole focus.<
In summary, a static allocation to a bond fund in a rising rate environment is not good. It’s also something that should not simply be tolerated for the sake of passive diversification or historical status quo.
A Deeper Look:
To focus on the 1-3 year Treasury bond market, owning individual bonds has been the best path. Constructing a laddered Treasury bond portfolio in the last year, investors have been able to lock in roughly 3% - 5% yields across the 6 month to 3-year time period.
Meanwhile, the iShares 1-3 Year Treasury Bond ETF has been an uncomfortable ride for what I would consider default-risk-free capital…it’s all about rates:
iShares 1-3 Year Treasury Bond ETF
How other popular bond funds have performed:
iShares Investment Grade Corporate Bond ETF:
Vanguard Total Bond Market Index ETF:
The unfortunate reality is that most financial advisors incorrectly relied on the assumption of a 60/40 balanced portfolio for several years leading into 2022. During this era, bonds offered record low yields AND significant negative asymmetric risk.
Has the lesson been learned? For established bond fund allocations, it’s going to be a long-time to get back to prior $$ balances. For new investment allocations, certain bond strategies make sense – but don’t repeat prior fixed income investing habits.
Best,
Jon
The above charts cover 5-years as of March 14, 2023 and are NAV only, the income they distribute is not represented. For a complete review of the ETFs and their performance:
SHY: https://www.ishares.com/us/products/239452/
USIG: https://www.ishares.com/us/products/239460/
BND: https://investor.vanguard.com/investment-products/etfs/profile/bnd
HYG: https://www.ishares.com/us/products/239565/
Fed Balance Sheet History Chart:
https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm
Fed Fund Interest Rate History Chart:
https://fred.stlouisfed.org/series/FEDFUNDS
Disclosures: Western Level Advisors LLC ("WLA") is a registered investment advisor. The information provided in this commentary is intended to be informative and not intended to be advice relative to any investment or portfolio offered through WLA. The views expressed in this commentary reflect the opinion of the author based on data available as of the date this commentary was written and is subject to change without notice. This commentary is not a complete analysis of any sector, industry or security. This commentary is not intended to be a recommendation to buy or sell any investment. Please contact WLA with any questions regarding your accounts. The information provided in this commentary is not a solicitation for the investment management or other services offered by WLA. References incorporated into the commentary from third party sources are as of the date specified and are believed to be reliable. WLA is not responsible for errors in the third party data. Source information is provided under each chart. Additional disclosures are available at www.westernlevel.com.