January 13, 2022
Written By: Andrew Hallam
Have you ever left a piece of fruit on your kitchen counter for several days or a couple of weeks? I have. It’s disgusting. Uninvited families of ants stormed my kitchen. They telegraphed thousands of their closest friends. And as they dined on that fruit, they (the fruit, not the ants, unfortunately) began to shrivel. If I were starving when I came home, I suppose I could have eaten a dehydrated, mutilated, molding banana. But it likely would have led to diarrhea.
These days, plenty of people recoil at the thought of owning bonds, as if they (the bonds, not the people, fortunately) were decomposing fruit covered with insects or vermin. They cringe at bottom-of-the-barrel interest rates. They point to inflation and say, “Bonds are much like shriveling bananas.” OK, maybe they don’t say that. But perhaps they should.
For example, bananas left on a counter lose their appeal. They shrink. They stink. A 10 year-treasury bond is much like that banana. As I write this, it yields 1.72 percent. Below, I show annual US inflation levels over the past 5 years. In 2017, living costs (inflation) increased by 2.13 percent. In 2018, it increased by 2.44 percent and when the dust settled at the end of 2021, inflation had risen 6.8 percent, compared to the year before.
|Year||Inflation Rate (%)|
Stone-faced experts on TV say, “Inflation is bad for bonds.” But they fail to understand what happens in the jungle.
Sure, if you stick a banana on a counter for a week it loses volume and appeal. Such is also the case with a 10-year government bond. But a broad bond market index is like a banana tree. Such trees don’t bear seasonal fruit. They produce bananas all year long. A bond broad bond market index is much like that.
It comprises several bonds with different maturities. For example, when a 2-year government bond matures, the index fund provider is left with cash. Whether it’s iShares, Vanguard, Fidelity, Schwab, or any other index fund provider, the fund managers take that cash and buy another 2-year bond. If inflation has risen, the second two-year bond will offer a higher interest rate. In other words, a broad bond market index continues to replace its bonds, much like a banana tree keeps producing fruit.
So, when inflation rears its head, only people with long-term individual bonds or a long-term bond market index need to sweat. After all, insects and vermin (known as inflation) will devour their buying power. For example, Vanguard’s Long-term bond market index (VBLAX) has an average effective bond maturity of 23.4 years. That means, about half of the bonds in this thing will pay their current interest rates for almost a quarter of a century before they get replaced. That’s as appealing as a molding chunk of fruit.
A broad bond market index has shorter average terms. A short-term bond market index has shorter terms still. These won’t beat inflation every year. But over time, they should. And they won’t be anywhere near as volatile as stocks.
People aren’t going bananas over bonds these days. However, when stocks crash (and they will) investors with a broad or a short-term bond market index will be happy to have them. Such products are safety nets, ensuring that our portfolios don’t fall as far when stocks crash. Broad or short-term bond market indexes also offer dry powder when it’s time to rebalance. I own a globally diversified portfolio of stock and bond market indexes. So, when stocks crash, I’ll be much like an ant that just found a free meal.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas
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