Why Bonds, Why Now?

Why Bonds, Why Now?

The U.S. bond market was down 10.3% through the first half of this year. What’s worse, bonds fell in tandem with stocks, causing many investors to wonder if bonds had lost their power to protect portfolios and act as a dependable hedge against volatility.

The good news for bond investors is that the market rebounded in the second half of June and continued to make gains in July. The Bloomberg U.S. Aggregate Bond index was up 1.7% month-to-date through July 27.

The even better news for long-term investors is that bonds have a special quality that sets them apart: They are self-healing.

What do I mean when I say bonds are self-healing?

Well, the mechanism is simple: When you buy a bond, you are getting an investment asset that has a known outcome. Individual bonds have a maturity date. And when they get to that date, they mature at “par,” or 100 cents on the dollar. In short, the issuer has to pay back the money they borrowed on a specific date. This basic dynamic occurs even when interest rates are rising. So long as the borrower doesn’t default, the only way you’ll get less than the bond’s par value is if you sell before it matures.

Therefore, putting money back into the bond market even when rates are rising is not throwing good money after bad. Reinvesting principal and interest may sound counterintuitive as you see market values decline on existing positions. But by waiting it out and reinvesting, we eventually see the self-healing nature of bonds on display: Rising rates lead to higher bond fund yields and higher income payouts. To be clear, this may take time, but bond investors can afford to be patient because they get paid interest while they wait.

Let’s see how this played out for a real-life two-year Treasury bill over the six months before it matured at the end of June.

This chart shows how bond prices "self-heal" as they reach maturity, even if the bond market is falling.
Note: Chart shows daily market value (bond price) for the two-year U.S. Treasury 0.125% that matured on 6/30/22 as well as the daily cumulative return for the iShares Core U.S. Aggregate Bond ETF (bond market return) from 1/3/22 through 6/30/22. Sources: Bloomberg, Morningstar.

Over the period shown, the Treasury bond’s price fell and then recovered to par value even though rates were rising and the bond market was declining during the entire period. This quality is not unique to Treasury bonds—the same thing happens with municipal and corporate issues.

Seeing your bonds fall in price is never fun, but due to their contractual nature, bond prices will heal if only given time to do so.

Bond fund investors benefit from this phenomenon through a different means. The typical bond fund has no final maturity date and rising rates lead to lower share price NAVs, but they also lead to higher bond fund yields and distributions. When reinvesting bond fund distributions, you are acquiring additional shares at lower prices with higher yields. Your bond fund may hold hundreds or even thousands of bonds (Vanguard’s Total Bond Market Index fund had over 10,000 positions toward quarter-end) but make no mistake—a bond fund’s underlying positions have the same self-healing nature as individual bonds.

In other words, bonds continue to do their job. In the most difficult days, bonds produce income and balance risk. Even as the market value of our bonds fell along with the major indices in the first half of this year, bonds continued to earn and pay interest when due.

For informational purposes only; not a recommendation to buy, hold or sell any investment product. Past performance is not an indication of future returns. All investments carry risk of loss and there is no guarantee that investment objectives will be achieved. Speak with a financial adviser before taking specific action. The investment ideas and opinions contained herein should not be viewed as recommendations or personal investment advice or considered an offer to buy or sell specific securities. Data and statistics contained in this report are obtained from what we believe to be reliable sources; however, their accuracy, completeness or reliability cannot be guaranteed.

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