Even though the stock market gets a lot more attention, the bond market is roughly twice as big. We look at the three main types of bonds and how they have fared this year.
It is standard practice for investors to hold a certain percentage of their portfolios in bonds, seeking to offset the risk of their stock positions moving against them. 40-50% in bonds are pretty typical, with older investors leaning even more toward bonds.
The idea here is that if we get a stock market pullback, your position in bonds is supposed to cushion the blow, based upon the belief that bonds do well when you get a bear market with stocks, the sort that scare these investors.
Both the stock and bond positions are exposed to the market without the benefit of guidance, much like castaways put a note in a bottle and cast it upon the sea. Investors are aware of the risks of stocks, but do not choose to be aware of bonds enough to even know that bonds come with serious risks as well, even though the amounts being put at risk aren’t as large as with stocks.
Bonds can indeed buffer losses with stocks, and we saw that happen with this latest bear market, at least if you were hedged with treasuries and with not other types of bonds. They also can take away your returns when they are running in the wrong direction, both tamping down stock returns by diluting them with poorer relative average performance as well as incurring real losses when their price declines.
Investors will insist on this general bond hedge because that’s just what they believe, what they have been told to do. If people choose this course, rather than relying on bond hedging only when it makes sense to, when there is higher risk in the stock market, they should at least know the difference between the types of bonds and know which one actually provides this hedge.
When we don’t, this means that we have taken the punishment from the low average returns of bonds, and if we don’t even get the payoff if your bonds tank right alongside stocks when these things happen, then this plan really makes no sense,
Moves like the one we saw in February and March with stocks isn’t the real risk, when we just bounce back as we have done, it is the long bear markets that haunt investors, the ones of yesteryear. Our economies are much better managed now and we’ve had some pretty bad crashes over the last 20 years and have recovered fairly quickly from all of them, including this last one.
If you are a long-term investor, and these big pullbacks end up recovering fairly quickly, and you weren’t planning on selling during this time, there is no loss, not even a running one. If you measure total returns over the period that investors invest in and pick all stocks versus a diluted bond position, the all stock portfolio will do much better even though there may have been a few crashes along the way.
If we do engage in this sort of hedging though, we should be sticking to the types of bonds that actually do offer this sort of protection, shelter from whatever the economy may bring on, and not pick ones that are prone to economic shocks.
The three types of bonds that investors have to choose from are treasuries, corporate bonds and municipal bonds. Since we just had a stock market crash, we can take a look at how well these three types actually provided a buffer against this, as bonds are supposed to do.
Treasuries performed like a champ this time around, although this isn’t always the case and both stocks and bonds took a big hit during the 2008 crash. This time around, treasuries has a lot of upward momentum and were particularly helped by all that quantitative easing from the Fed, where they buy massive amounts of treasuries and raise the demand, price, and value of treasuries considerably.
How These Bond Types Have Stacked Up This Year
The benchmark iShares 20+Treasury Bond ETF is up 23.6% on the year, being only surpassed by the very best performing stocks in the market. Money put into this certainly earned its keep in 2020, and once the crisis started to hit, this was a legitimate time to move all your money to treasuries to flee the crash.
This fund has a 5-year performance of 8.4%, which isn’t quite up to what the S&P 500 returns but it still has competed with it pretty decently. The problem with this hedge going forward is that treasuries have been in a strong bull market for a long time and this will be coming to an end soon. The current levels are way below even historical lows and as the price normalizes, this will involve proportional losses.
Corporate bonds might be a type of bond but they do not share the same hedging qualities as treasuries do, and it’s not hard to figure out why. When we get into situations where the world becomes worried about companies, they worry both about their stocks and their bonds, and this means that their bonds go down in value as well.
The iShares iBoxx $ Investment Grade Corporate Bond ETF is up 1.73% for the year, but it took the Fed to come to the rescue of these bonds, otherwise they would be a lot lower. Corporate bonds were in free fall in March, where this index lost 23% in less than 2 weeks before the Fed stepped in to save them.
The 5-year performance of this corporate bond index is 5%, considerably lower than with treasuries, even though corporate bonds yield more. This is where investors get really confused, thinking that it’s the yield that they make their money from, and don’t understand how changing bond prices affect the value of the shares they hold in bond funds.
This return is a little over half of what the treasury fund earned over this time, without the benefit of the hedge that treasuries enjoy. Buying corporate bonds just ends up choosing a much lower return without getting anything much back at all for it.
Municipal bonds, or munis, pay even lower returns and aren’t a good hedge against stock market crashes either. Negative economic events impact both businesses and state and local governments that issue these munis and these bonds suffer as well.
While the Fed puts up the price of treasuries in times of trouble, both corporate bonds and munis are left to bear the brunt of this trouble. The Fed has said it will help certain smaller governments, the bigger of them, but their coverage has been on the thin side so far.
It’s not as if muni bond funds are going to collapse, and they should be able to get out of this given that the worst is over, but they did get quite a shock earlier in the year. The VanEck Vectors Short High Yield Municipal Bond Index crashed by 34% in March, and while it has come back a fair bit, it still sits down 11.7% for the year.
It us up for the last 5 years, but only by 0.2%. This has really lowered our return, down to practically nothing, and hasn’t provided us any protection against the coronavirus either. People are attracted to the fact that you don’t have to pay tax on what you make with muni bonds, but somehow, making near to nothing and being considerably worse off is seen as plenty tempting.
The trick that they use is to compare the yield with a muni to one with a higher yield, one carefully selected for this purpose, deduct the tax at the highest tax bracket, and see the muni yielding a comparable amount after tax.
You Can’t Ignore Price with Bonds as This Determines Their Value
This completely ignores the price element of bond funds though, and making 0.2% a year over the last 5 years versus the 5% that our corporate bond fund made and the 8.4% that the treasury bond fund earned demonstrates this effect very well.
These returns include not only the interest payments that bonds pay but the movements in their price over time as well. The price of a bond is driven by the market, by the supply and demand for it. Treasuries are the most in demand, while munis are the least.
The actual yield on treasuries over the last 5 years was far less than the 8.4% a year that this fund averaged, and the great majority of these returns were gained by the value of these treasuries rising over this time. Munis don’t rise very much at all and this does matter because their meager returns are what you will be left with if you choose them.
People buy munis to save taxes though, and the fact that so many do tell a lot about the utter lack of thought that goes into these decisions. As the years go by and they see these crappy returns, they still don’t do the simple math here by comparing after tax returns between bonds and are happy enough to stand pat without checking any of this out.
The funniest part of all this is that people mix up their bond holdings to seek diversity, to spice up otherwise boring treasury funds. They get confused by yield as always, seeing the yield higher with other bonds and then think that this means that they will get a higher return from them.
In reality, as we have seen, they can end up choosing a lower return than treasuries provide, in addition to holding bonds to hedge that don’t even hedge well.
There are times where treasuries may be the worst place to be, when they turn bearish, like for instance what would happen if treasury prices fall quite a bit going forward as they are expected to. In this case, being in corporate bonds can clearly be better, when corporate bonds are holding their value while treasuries sink.
You have to be willing to take a peek to be aware of any of this though, something that very few bond investors are ambitious enough to do. Buying index funds, including bond index funds, takes most of the thinking out of investing, but not all of it.