Bond Market Is Crashing (I'm Still Buying)
The bond market hasn’t looked that great the past few years. But that doesn’t mean bonds shouldn’t continue to be a crucial part of our portfolio. In post I want to help you understand why you should still consider investing in bonds despite its pitiful performance the last few years, as well as review 3 best bonds funds I personally recommend to hold in your portfolio.
Bond 101
Before we get into what’s going on with the bond and what best bond funds to buy, let’s briefly talk about the basics of bonds in the first place. And why we would even want them in your portfolio. In the simplest term, bonds are loans. When you buy bonds, you are essentially loaning money to someone. In this case to a company or a government agency. And they are an important addition to a well constructed investment portfolio because of how different they are from stocks.
A good analogy I like to use to frame stocks versus bonds is to think of them like engine vs. the break. Think of stocks as your core wealth building engine. Without it, you aren’t really going anywhere. And think of bonds as your breaks. Without it, you could drive yourself off the road. When you have bonds in your portfolio, it helps to smooth out your investment ride because though they have lower returns, they have less volatility. The general rule of thumb is that you want to start adding them to your portfolio as you get closer to your retirement age.
Alright, but with that said, if you look at the latest bond market trends you might have noticed a few things. They’ve been falling. For example, Vanguard Total Bond Market Index Fund also known as VBLTX has fallen by more than 15% since the beginning of this year. So what gives?
But Bonds Have Been Falling
Yes, when we look at the past year, bonds have had a pretty rough time. Based on some numbers, this could be the most devastating period for bonds since at least 1926. So you might have doubts about putting more money into the bond market.
However, as bad as things are now, history and basic fixed income math will tell us that we should start seeing some relief when the interest rates stop rising. Thus the greater importance of ignoring the turmoil of the market and just hanging onto well-diversified holdings in low cost bond index funds that we will review in this post in a bit. Of course we don’t know exactly when that will happen, but most bond investors should expect to benefit if they can ride out this upheaval and hold onto their bonds.
How can we be sure of this? Let’s understand how the bond market moves in relation to interest rates. Bond prices and interest rates move in opposite directions. That is simply the way bonds work. Rise in rates leads to drop in existing bond prices as newer higher yielding bonds are issued. And when there is a steep rise in rates as it is happening now, a steep dip in bond prices.
It’s easy to forget that the Fed was holding the federal funds rate at around zero as recently as the first quarter of 2022. But once the Fed decided it was time to do something about inflation, it moved forcefully and raised the fed funds rate by three percentage points in about six months. The current federal fund rates are between 3.75% to 4.00%. But if history can teach us anything, this has happened before, and we have recovered from it before.
Paul Volcker, Chairman of the Federal Reserve from 1979 to 1987
The last time the Federal Reserve had to deal with inflation this high was in the early 1980s during the start of the Reagan Administration. Paul Volcker, who took over as Fed chair in 1979, vowed to raise rates until inflation got under control — no matter how much it slowed down the economy. Volcker argued the short-term economic pain far outweighed the long-term damage of inflation. If you can believe it, at one point the Fed's benchmark interest rate rose as high as 20%. Puts our 4.00% in perspective right?
Then after tightening rates for several years, Mr. Volcker decided in the latter half of 1982 that it was time to relieve the economic pain. That was a turning point. Interest rates fell and the market rallied. For bonds, according to several measures, it was the best year of the last century. The Bloomberg U.S. The Aggregate Bond Index had an average annual return of 32.62% in 1982. And had positive returns every year for the next decade
Now I’m not saying that identical things will happen this year or next year. Because none of us can predict the future and timing. However if we are long term buy and hold investors, the history and fixed income math should give us some sense of direction and hopefully comfort. Despite the weakening economy, bonds should eventually rally back up once interest rates start falling again.
Some experts are even saying that it's likely most of the damage in the bond market has already been done. The average yield for high-quality bonds in the Bloomberg Aggregate index is already almost 5 percent because interest rates have risen so rapidly.
Now however, the forecast for the overall economy is a different story. With average mortgage rates at 7%, the housing market is definitely feeling the impact. And when we add up all the events happening around the world; continual war in Ukraine, lingering pandemic and energy shock, it wouldn’t be a surprise if we fall into a recession soon.
But like all cycles in the past, when the economy weakens and unemployment rises, inflation should come under control and by then the Fed will decide that it needs to relieve the economy and start pushing down the interest rate to stimulate more spending. And the cycle will begin again. When we wind the clock back to 1982, we see an example of where the Fed made the interest rate pivot and both the bond and the stock market embarked on a long journey up since then.
Now nobody can say with certainty if that will happen going forward but I myself am confident that with a long-term perspective of the future, the bond market will start to make its pivot and it will continue to be a crucial component to our well balanced portfolio. This is also a good time to point out why it is so important to hold a healthy level of cash in your checking or savings account.
The market cycles come and go but it's almost impossible to predict the timing of all this. When will the Fed start to lower interest rates again? When will inflation come back down to a healthy level? I wish I knew.
Therefore you want enough cash to be able to ride out the many unpredictability and the bumps of your investing journey. We never want to place ourselves in a position when we are forced to sell assets that have fallen in value because of personal liquidity issues. Hold cash and hold a lot of it if possible.
Now with that said, you also want to make sure you are holding onto the right bonds funds. Because in order to benefit from the rally up of the bond market you want to hold funds that are netting new investments in bond funds by replacing low-yielding bonds with higher-yielding bonds. And the best funds that are doing that are low cost bond index funds with built in self cleaning mechanisms. Here are what I consider the 3 best Bond index funds to include in your portfolio.
Vanguard Total Bond Market Index Fund, VBTLX
The first bond I recommend is the Vanguard Total Bond Market Index Fund also better known as VBTLX. Here are some facts:
Expense ratio of 0.05%.
Represents 10,174 individual bonds.
$3,000 minimum investment requirement.
The fund’s investment objective is to seek to track the performance of a broad, market-weighted bond index therefore it tracks the Bloomberg U.S. Aggregate Float Adjusted Index. This one fund provides broad exposure to the taxable investment-grade U.S. dollar-denominated bond market, excluding inflation-protected and tax-exempt bonds.
When you hold a broad market weighted bond index that tracks very high quality bonds, alot of the risks of holding individual bonds such as default, interest rate and inflation risks are all mitigated.
Also if investing $3,000 seems like a tall order, you could also consider the ETF equivalent. The Vanguard Total Bond Market ETF, also known as BND. The nice thing about BND in addition to not having a minimum is that it has a lower expense ratio of 0.03%. Though you want to weigh the pros and cons of investing in an ETF versus a simple index fund. Another nice thing about starting out with an ETF is that you can convert to an Index Fund once you hit the minimum of $3,000.
Fidelity US Bond Index Fund, FXNAX
The second bond I would recommend is the Fidelity U.S. Bond Index Fund also known as FXNAX. Here are some facts:
Expense ratio of 0.025%.
Represents 8,430 bonds.
$0 minimum investment requirement.
It tracks the Bloomberg Barclays U.S. Aggregate Bond Index which is composed of investment-grade government bonds, corporate bonds and mortgage backed securities. The top issuers are the US Treasury or issuers of Mortgage Backed securities like Fannie Mae and Freddie Mac.
And a nice aspect of investing with Fidelity and with FXNAX is that there is no minimum to invest. You can start investing with whatever you have. If you are already investing with Fidelity and have been looking for a solid bond fund to hold, I highly recommend the Fidelity® U.S. Bond Index Fund.
Schwab US Aggregate Bond Index Fund, SWAGX
The third bond I would recommend is the Schwab U.S. Aggregate Bond Index Fund also known as SWAGX. Here are some facts:
Expense ratio of 0.04%.
Represents 8,090 bonds.
$0 minimum investment requirement.
It tracks the Bloomberg US Aggregate Bond Index. A broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities and mortgage backed securities.
The top issuers are also the US Treasury or issuers of Mortgage Backed securities like Fannie Mae and Freddie Mac. If you are already investing with Charles Schwab, I highly recommend the Schwab U.S. Aggregate Bond Index Fund to round out your portfolio.
I know bonds are a complex and a broad topic and we’ve only covered the surface of it in this post, but I hope it gives you some context to the current bond market. The bottom line is don’t be afraid to hold some bonds in your portfolio. If you are just starting to dabble into the bond funds, start small so you can get used to holding them.
