Your Bond Fund Took a Hit? Stay Put
It’s a crucial hedge against other unpleasantness
If you took a look at your first-quarter 401(k) statement, you likely noticed your core bond fund lost nearly 4% in the first three months of 2021. That’s a bit of a hole to climb out of, when you consider that right now the average yield for core bond funds is less than 2%. Basically, in the first quarter, the price of bonds fell more than two years’ worth of interest payments.
Frustrating? Absolutely. But the case for owning bonds has not changed for long-term investors.
Remember why you own bonds
Bonds are your best friend when stocks get ugly. In the first quarter of 2020, when the pandemic sent the U.S. stock market into a bear market, your bond fund held its ground, gaining around 3%.
Back in the fall of 2018 when stocks all but officially had a bear market (the S&P 500 lost more than 19% between early September and Christmas) the Bloomberg Barclays US Aggregate bond index, the benchmark for core bond funds in 401(k)s, gained 1.6%.
During the past five years, the S&P 500 has more than doubled. Your core bond fund has likely gained more than 15%. For the record that beats the 11% rise in inflation, so bonds preserved your purchasing power. Cash? Not likely, as top low-cost money market mutual funds didn’t earn more than 6%.
Anatomy of a bond bear market
There’s universal agreement that a bear market for stocks is when the major indices fall at least 20% from their previous high. But there’s no such straightforward metric for calling a bond bear market. Kathy Jones, chief fixed income strategist for the Schwab Center for Financial Research, suggests a 1 percentage point (100 basis point) rise in the yield of the 10-year Treasury note constitutes a bond bear market.
A quick reminder: When yields rise, bond prices fall. The total return on your bond fund or exchange traded fund is the combination of yield plus changes in price. Though rising yields are good news in the long-term (you’ll collect more income), the initial price hit when yields are climbing can result in negative returns.
We’ve recently blown way past a 1 percentage point rise in the 10-year Treasury. In early August 2020 the yield for the bellwether bond had fallen all the way to 0.52%. At the end of the first quarter of 2021 the yield was up to 1.75%.
Back to sorta-normal?
As with just about everything financial these days, the big change in bond yields is all about pandemic fallout.
The recent sharp and fast rise in yields is a reset now that vaccinations are plentiful, and the economy is expected to shift into a higher gear. Before the pandemic closed down the global economy, the 10-year Treasury yielded more than 1.8%.
Jones, of Schwab, suggests the yield might make it above 2% or so in the coming months.
The fact that the Federal Reserve keeps signaling it has no intention of raising its key interest rate — the federal funds rate — until 2023 will likely keep longer-term interest rates from moving much higher in the near term. Moreover, while U.S. bond yields have moved higher, globally, most government bond yields remain well below 1%. With global investors already getting much higher yields here, there’s less impetus for U.S. bond yields to have to move higher to attract buyers.
A yield of 2% or so is indeed better than 0.50%. But it’s still quite low. Before the financial crisis, the yield on the 10-year Treasury hovered in the vicinity of 4%. In the past five years there was only one brief moment (the fall of 2018) when it climbed above 3%.
The real problem
The recent 1.7% yield for the 10-year Treasury is before factoring in inflation. The term “real yield” refers to the yield after subtracting inflation. A positive real yield tells you if your bonds are earning enough to maintain your purchasing power. Right now, the safest bonds — U.S. Treasuries — have a negative real yield. While the yield has climbed, so too has inflation. The real yield for the 10-year Treasury in mid-April was around -0.70%.