You've changed, bonds. Not cool
We talk about stocks because they are more dramatic and exciting. But it is bonds that really make capital markets function. There are over half a million corporate bonds issued in the US. By comparison, there are only 4,000 listed US corporations. Those 500,000 bonds only represent 20% of the total bond market by dollar value. The rest come from municipal bonds, the United States Treasury, and mortgage-backed debt. It’s estimated that the global value of bond markets is about 50% larger than the global value of listed stocks.
Bonds are traditionally considered ‘safe.’ Here’s a chart of how the US bond market did in 2020 when we had the pandemic crash. That red line is bonds, and they stay above the fray. If you couldn’t afford to lose money in 2020, hopefully you were in bonds or cash. On the other hand, if you are a long term investor, you can see that stocks eventually outperformed and you shouldn’t care about a crash today.
If you checked your 401k statement for the last quarter, you lost money. (If you didn’t, I want to invest with you!) Even your usually boring and reliable bonds are down a lot. Bonds, broadly, are down more in the last three months than any same period since 1980.
Worse, they are going down at the same time stocks are going down, another rare occurrence. Since last September the entire US bond market is down more than the entire US stock market by 5%!
What the hell, bonds? You changed. Not cool. There have been only three years since World War 2 where the 10-year treasury bond had bigger losses than the S&P500. (In April 2022, the S&P500 was down about -7.5% and 10-year treasuries were about -10%.)
Searching for answers, you check your favorite financial news and hear the bond decline is due to ‘rising interest rates’. Those are words you see so often that you would be forgiven for thinking everyone else in the world fully understands their meaning. Few do!
Every basic investment test in history has had a question asking about the relationship between interest rates and bond prices because it’s hard to grasp. When interest rates go up, bond prices go down, and vice versa. We can forgive the 40% of self-described ‘active personal investors’ that get the relationship wrong. Even in my Certified Financial Professional classes, the instructor would say, “It’ll take too much time to explain it, just memorize it.” (Yes, I passed the CFP exam. And yes, the question was on there.)
You know that bonds are debt and you, the buyer of bonds, are the lender. You pay them a big sum today (usually $1000 per bond) in return for smaller payments over time with interest. If you were to buy a 10-year high quality bond at 5% interest you would receive a yearly $50 payment for the term of the bond (anywhere from 30 days to 30 years) assuming you bought the typical $1,000 face value bond.
Five years later, interest rates have gone higher to 6%. The same company that issued your bond is now issuing new bonds paying $60 per month for the same $1000. ‘Well crap’, you say, ‘I’m gonna sell my bond and buy a new one at a higher rate’.
But who will buy your $50/month bond when, for the same price, they can get the $60/month (6%) version you also want? No one will. You have to lower the price. In simplified terms, this illustrates the relationship between interest rates and bond prices.
Why are interest rates rising? That’s a harder question to answer, but it’s related primarily to inflation. Higher interest rates eventually cool-off inflationary pressure in a stable economy (but it can get ugly!).
Typically when stocks are doing poorly, especially when it’s an indication of economic weakness and not a bubble, the Fed like to keep rates stable or even reduce them, causing bond prices to go up. But it can’t do that right now. The Fed is calculating that the risks of inflation are greater than the benefits of keeping rates stable.
And thus, everything is going down, all at once. It’s a good reminder that patterns we are accustomed to, like ‘bonds for safety’ do not always work out.
