What are Some Pitfalls of Bonds Today, and When will they Subside?

Quiz!

Which of the following statements are true? (There may be multiple answers.)

1. Short-term bonds are attractive today, given their high interest payments.
2. Short-term bonds are appealing whenever there is a large upcoming expense.
3. Short-term bonds enjoy low volatility.
4. Long-term bonds are attractive today, given their high interest payments.
5. Long -term bonds are appealing whenever there is a large upcoming expense.
6. Long-term bonds enjoy low volatility.

What are Some Pitfalls of Bonds Today, and When will they Subside?

Bonds offer much higher interest payments these days compared to 2 years ago. They are appealing for various uses. They are especially useful if you prefer/need to moderate the volatility of stocks. When deciding on a bond allocation, it is worth paying attention to the following pitfalls:

1. Short-term bonds: After inflation and taxes, it is tough to get substantial income, and often the net real income is negative. For example, a bond paying 4%, to a person with 25% income tax rate, nets 3% income. With inflation of 4%, this leads to a -1% return. Tax-free municipal bonds address the tax penalty, but at a price of lower income, that also faces the inflation headwind. It is not a reason to avoid using them, but important to be aware of the issues when deciding on the allocation.

2. Long-term bonds: Long-term bonds sometimes (not always) enjoy higher income but face an additional problem: the risk of rising interest rates. Historically, once inflation reached a 9% level, as happened last year, it took a median of 10 years to go back to normal.  So, without any bad luck, the bond becomes a risky investment for extended periods. The price of a 20-year bond paying 4% per year changes by 13% for every 1% change in interest rate. Compounding the declines for a 4% rate increase causes about a 40% decline. If you hold the bond to maturity you avoid the interest rate risk, but still have inflation risk. In addition, there are more compelling investments for long-term holding periods.

When would the risk of long-term bonds go down. Once Core PCE inflation (the measure that the Fed tracks) gets closer to 2%, the Fed may feel confident enough that it completed addressing the high inflation, and will more likely stop raising interest rates. While there are many factors affecting interest rate decisions, this is a prominent risk factor for bondholders.

Note that this article only pointed out a couple of risks of bonds today and is far from a comprehensive review of bonds. There are many types of bonds that are appropriate for different uses at different times.

Quiz Answer:

Which of the following statements are true? (There may be multiple answers.)

1. Short-term bonds are attractive today, given their high interest payments.
2. Short-term bonds are appealing whenever there is a large upcoming expense.
3. Short-term bonds enjoy low volatility. [Correct Answer]
4. Long-term bonds are attractive today, given their high interest payments.
5. Long-term bonds are appealing whenever there is a large upcoming expense.
6. Long-term bonds enjoy low volatility.

Explanations:

1. While high interest payments are more appealing than low interest payments, you need interest payments materially above inflation to give appealing after-tax growth or income. Other investments can do this job better.
2. Not knowing anything else, this statement is true: short-term bonds are appealing when there is a large upcoming expense. There is an important exception to this statement: when the total withdrawal rate (including the unusual expense) is low enough, it is possible to enjoy the benefit of stocks while supporting the unusual expense, as long as the investor is perfectly disciplined. Some large expenses can be broken down to a series of smaller expenses, alleviating the need for bonds. Examples are student loans and mortgages.
3. Correct: Short-term bonds indeed enjoy low volatility.
4. Long-term bonds seem attractive today, given their high interest payments, but they can decline in the face of rising interest rates.
5. Long-term bonds are not appealing for large upcoming expenses. They can decline significantly in the face of rising interest rates, as seen in 2022.
6. Long-term bonds fluctuate a lot more than short-term bonds with changes in interest rates. They have lower volatility than stocks, but not always low volatility.