Physicians' Guide to Wealth

A guide for anyone pursuing financial independence

Q
Done with Bonds

Aug 17, 2022

For those with corporate and government bond funds or index bond funds in their account, the next 12 to 20 years may be a long-term declining trend. Bonds are sensitive to interest rates in which bonds correlate opposite to interest rates like a teeter-totter. If interest rates rise, then bonds decline and vice versa. If history is an indication of the future, interest rates will continue to rise for the next 12 to 20 years, and that is bad news for bonds. Below are the returns of the iShares Corporate Bond Index and 20-Year Treasury Bond Index for the past year:
➤ iShares Corporate Bond Index Fund -10.93%
➤ iShares 20+ Treasury Bond Index Fund -23.79%
These are huge losses for a sector that is supposed to provide a hedge against declining stock markets and inflation. For many, a standard process of evaluating an investment is to review past performance. When it comes to corporate and government bond funds, past performance will definitely not represent the future. In fact, most income funds that may perform well for the next decade have marginal past performance records. These two funds, for the past 20 years since their inception, have been staples in most portfolios for the consistent dividend yields and steady appreciation of the fund share price. 
 
Here is how they have performed the past 20 years up to June 2020, not including dividends:
 
➤ iShares Corporate Bond Index Fund 18.47%
➤ iShares 20+ Treasury Bond Index Fund 99.93%
You can understand why people will be misled by these terrific past performance returns. However, in evaluating any investment and its past performance, one must determine why the investment did well and will the same circumstances occur in the future. For bonds, the past success is simply the result of a multi-decade declining trend of interest rates.  
 
History buffs will remember the prime lending rate peaking on December 19, 1980, at 21.5%! Since then, it’s been a long downhill trend for interest rates and steady appreciation for bonds. But that trend ended in late 2020 as the Covid crisis abated and the 10-Year Treasury yield dropped to never-before lows of 0.5%. Following the 2008 Great Recession and housing crisis, Janet Yellen, former Federal Reserve Chairperson, lowered the Federal discount rate to an ultra-low rate of 0.25%. Central bankers around the world, to fend off their economic crisis, dropped their government rates to 0% and many to negative yields (the government paid the borrowers). Clearly, one would have considered this period the bottom of interest rates and soon the beginning of rising interest rates. However, the recovery was slower and central bankers did not have the confidence in their economy to raise their rates. Janet Yellen was the first and, for many quarters, the only central banker to smartly raise rates to begin building reserves for the next economic slowdown; fortuitous for Jerome Powell, current Federal Reserve Chairman, who had the reserves to lower rates during the Covid crisis.
 
At the start of 2021, the Covid crisis and subsequent supply chain issues created a whipsaw of wild swings in prices due to the imbalance of supply to increasing demand. To fight off a potential runaway economy with hyper-inflation, Jerome Powell starts raising rates at the beginning of this year. The aggressive rate increase policy by the Federal Reserve has had a very negative impact on the corporate and government bond sectors, as illustrated above.
 
Again, if history is an indication of the future, the recent rate increases are just the beginning of many years of continued increases. If this is the case, the worse is not over for corporate and government bond funds. 

What Does This Mean to Me?

If you own corporate or government bond funds in your taxable or retirement plans, we recommend reducing your allocation to them or replacing them entirely. Below are options to consider in replace of corporate or government bond funds with a brief explanation:
 
➤ Money market, Certificate of Deposits, or Fixed Income Stable Value (available in retirement plans only).  
o Principal guaranteed against a decline
o Yield increases with interest rates
 
➤ High yield bonds
o Higher dividend yield than investment grade bonds 
o Less sensitive to interest rates
o Sensitive to stock market trends in which a good market is good for high yield bonds and vice versa
 
➤ Strategic Income
o Diversified bond fund with investment derivatives to hedge against rising interest rates 
o Higher dividend yield than investment grade bond funds
 
Also beware of Target Date funds or Asset Allocation funds as these funds include allocations to investment grade and government bonds that you can’t control. These are multi-billion dollar funds managed by well-defined investment policies using “Modern Portfolio Theory” that always include bonds in their allocation.  
 
Call us if you have any questions about your account or this Weekly Brief. We are here to help.

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