Bond funds took a hard hit this year, as interest rates climbed sharply – and are likely to keep rising. This is not just very bad news for bond fund holders; it contradicts the long-standing belief that equity portfolios can be effectively diversified with bond funds.
To be sure, bonds can still be excellent investments. It is just that bond funds are not good proxies for individual bonds – at least not in the same way equity funds are good proxies for individual equities. This is a crucial distinction that has big implications when it comes to the construction of an investment portfolio.
Bond funds are pools of individual bonds, in the form of ETFs (like the iShares AGG
Take, for instance, a simple bond fund like IEF
This is stated explicitly in the methodology of leading fixed-income indices such as the Bloomberg U.S. Bond Aggregate family against which many bond funds are benchmarked. In their words,
“There is usually a lengthening of an index’s duration each month due to cash and bonds that are being dropped from the index often having lower durations than the bonds that remain in or enter an index.”
With the Fed in a rate-hiking mission, bond funds are doomed to continue their money-losing record. This may be hard to accept for some market participants, because they have had a good run with bond for 40 years. Since 1982, the super-cycle of declining interest rates gave bond portfolio managers the built-in advantage of buying their fund constituents at low prices (high rates) and selling them at higher prices (lower rates). This trend is now starting to reverse, and is turning this process-driven bonanza into a curse.
Even a supposedly safe fund such as SHY
This, however, does not mean that investors should avoid bonds. Individual bonds can still provide excellent diversification and decent returns to offset losses in equity portfolios. This will not be an easy transition for many.
A good number of retail investors perceive the bond market to be complex and opaque – understandably so. The bond market is huge: $53T in the U.S. at the end of 2021, according to SIFMA. But it is atomized into tens of thousands of bonds. Just the U.S. Treasury market alone includes 181 T-bills, 118 T-notes, 115 T-bonds, 152 TIPs and 114 Floating-rate notes, among many other securities. There are also municipal bonds, agency bonds, and corporate bonds of financial institutions like Citigroup
Many of them are quite illiquid because of their small size; some are bought as soon as they are issued and then buried in portfolios until maturity. In addition to the overwhelming numbers of bonds outstanding, they can be complex, usually coming with call features, “make-whole” provisions, minimum lot sizes, changing ratings, etc.
Because of these hurdles, investors may find that they need the help of an advisor to find the bonds that are most appropriate for their situation, and they should do that sooner rather than later if interest rates continue to rise, as it is widely expected.
The crucial point when investing in individual bonds is that they must be held to maturity to receive the promised yield. Otherwise, they confront the same problem as bond funds: uncertainty about the exit value, liquidity risks and high vulnerability to rising rates.
Good opportunities are available for investors ready to accept some credit risk. As an example, Royal Bank of Scotland’s 6.125% bond due on 12/15/2022 recently traded with a yield-to-maturity of 3.4%. While its credit rating is far lower than that of the United States, an investor that thinks that it is unlikely that RBS could default on its obligations within the next 6 months would be much better off with that bond than with bond funds, which are at high risk of losing money as rates go up.
Investors should understand that bond funds and individual bonds are fundamentally different instruments, unlike equity funds and individual stocks which share many investment characteristics. With rising rates, individual bonds held to maturity are poised to deliver a much better performance than bond funds held for similar periods. The case for switching out of bond funds and into individual bonds at this time is strong for those who seek effective diversification against equity positions.