There are several ways to gain immediate attention. You could stand on a busy street corner naked. You could scream profanities in a shopping mall. Or, if you’re a journalist, media mogul or social influencer, you could announce that bonds are risky. Grandstanding in the buff or cussing in public might get you arrested. Claiming bonds are risky, however, won’t land you in a squad car. But it might scare more people than a naked lunatic on a corner. After all, many investors view bonds as the most stable component of their portfolios. Anyone who challenges that brings on fear.
True, bonds pay lousy interest. But they prevent diversified portfolios from falling too far when stocks plunge. As a result, they can prevent investors from wetting the bed when stocks go off a cliff. In some ways, bonds are like seatbelts. If we drive into a ditch, they won’t necessarily save our lives, but they do increase the odds. That’s why bond-bashing headlines really freak people out…especially risk-averse investors who might own more bonds than stocks.
Such headlines, unfortunately, paint all bonds (or bond products) with a single brush. So let’s break down levels of risk:
The riskiest fixed-income products are high-yield corporate bonds. They pay high interest rates because they’re risky products. If you invest in a single company’s bond and the business goes bankrupt or defaults on their loan, bond investors lose. Funds of high-yielding corporate bonds pose slightly lower risks because the money is loaned to several corporations. Such funds include the iShares iBoxx High Yield Corporate Bond ETF (HYG). It pays interest of more than 4 percent per year, but high yield bonds always dance with high risk.
How about U.S. treasury bonds? Depending on what you buy, they could also hurt. For example, imagine buying a 30-year U.S. treasury bond today. These are safer than corporate bonds because the U.S. government backs them. However, with such a treasury bond, you would only earn about 1.65 percent interest for 30 years. If inflation runs higher than 1.65 percent (which historically, it has), that bond wouldn’t keep pace with the rising price of oatmeal.
You could lower your personal risk with long-term government bonds if you buy several wrapped up in a single fund, such as Vanguard’s Long-Term Bond Index Fund (VBLAX). But most of the bonds in this fund mature after 2031, so inflation could also eat this thing for lunch. That’s why risk-averse investors shouldn’t own it unless it’s part of a Permanent Portfolio, which I explain here.
For investors seeking lower risk, Vanguard’s Total Bond Market Index (VBMFX) is a more suitable product. Its holdings include U.S. government and AAA corporate bonds (not high-yield corporate bonds). Think of this as a faster revolving door of bonds. If interest rates rise (or inflation rises) newly issued bonds will reflect those rates. When one of the bonds in this index matures, the fund managers buy another similar bond. If interest rates or inflation increases, managers replace maturing bonds with those at a lower price (bond prices drop when interest rates rise) or the firm replaces the maturing bond with a newly issued bond that reflects a higher interest rate.
Funds such as Vanguard’s Short-Term Bond Index (VBISX), however, are even safer when bond prices drop. This fund is similar to Vanguard’s Total Bond Market Index, but the maturity dates of the bonds are far shorter. Think of this bond index as an even faster revolving door. Most of its bonds, for example, mature within 1-3 years, and when they mature, they get replaced right away. In other words, if bond prices drop fast or interest rates soar, this bond index is primed to buy new bonds at the lower price (or higher interest rate) because its bonds mature quickly.
This bond index, however, pays a low interest rate. And in five of the twenty-five years since the fund’s inception, it lost to inflation (2004, 2005, 2016, 2017 and 2018). However, it has yet to experience a calendar year loss. That doesn’t mean it won’t. But based on how quickly its bonds get replaced, any losses would be slight and very short-lived. DFA’s Short Term Extended Quality I bond fund (DFEQX) is a similar low-risk product with an even better track record.
So the next time you hear a fear-monger saying, “You shouldn’t own bonds,” or “Bonds are going to crash,” view this with perspective. First, nobody can predict short-term stock or bond prices. Bond market products also differ from one another. It’s easy to gain attention by trying to scare people. But a little bit of knowledge should put you at ease.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas