Bonds have been having a rough 2022.
Though to be fair, pretty much every asset class has too. The S&P 500 officially hit bear market territory in June 2022, Europe and the international markets are also down about 20%. Canada has been the over-performer this year, losing “only” 10% YTD, our export-heavy economy benefitting from the rise in oil and wheat prices caused by the war in Ukraine.
Bonds are usually supposed to be anti-correlated to the stock market, meaning that when stock markets go down bonds are supposed to go up as investors flee from risky assets to safer ones. That didn’t happen this year which is highly unusual, but then again inflation at 40-year highs is also highly unusual.
All this has led to a loss of investor confidence in bonds, which has only accelerated their decline. The Canadian bond index has, so far this year, declined by 14%. The US one is down 12%.
Again, highly unusual for bonds to move this much in either direction, so this is certainly an interesting time to be an investor.
That being said, I don’t think the current disdain for bonds is justified. I may be in the minority of investors right now, but there is a scenario in which owning bonds makes sense again, and I think that scenario will be coming up soon.
Why We Reduced Our Exposure To Bonds
We actually don’t have a lot of bonds in our portfolio right now. As we wrote about in our 2021 portfolio update, our yield needs suggested that we could afford to take on a more equity-heavy portfolio, so we re-balanced to 90% equity/10% fixed income. Right before stock markets started diving, as luck would have it.
To be honest, that decision wouldn’t have made much of a difference. The biggest counter-weight to the free-fall in stock markets right now is not bonds. Rather, it’s our Canadian stock market exposure. And that was, of course, blind dumb luck.
One deliberate move that we did make way back in April 2021 was to swap out our medium term aggregate bond fund for a short-duration bond fund. Because interest rate moves affect longer-duration bond values more than shorter-duration bonds, this is a move you do if you believe that central banks were going to raise interest rates in the near future, which at the time, I did.
Was this a little bit of active investing on my part? Technically…yes. I was betting on a future outcome that I didn’t know with 100% certainty.
But come on! At the time interest rates were at zero. The world was getting vaccinated (though with fits and starts) and it was starting to look like we weren’t ALL going to die a horrible death from this damned disease, so it stood to reason that interest rates would have to go up. I mean, there was just no other direction for it to go!
Anyway, at the time I had no idea that inflation was about to bite the world in the butt. Back then, the biggest story about Ukraine and its president was the time Trump tried to blackmail Zelenskyy to get dirt on Hunter Biden and then got impeached for it. It was…a simpler…time, I guess?
That being said, even though I didn’t foresee all the shit that would happen in 2022, I turned out to be right on my interest rate call. Central banks started hiking their main benchmark rate in March 2022 and it looks like they’re not going to stop any time zone. And as a result, being in short bonds turned out to be the right move.
Since I made that call, short bonds declined a lot less than the aggregate bond index did, and unfortunately, these days declining less than the average is considered a win, so…yay?
BUT, I know I can’t just hide out here on the short end of the yield curve forever. Eventually, I have to restore my original medium-term bond fund, and that takes me to our exit strategy…
When Bonds Start Looking Attractive Again
Vicki Robin and her husband Joe Dominguez wrote Your Money or Your Life. It was one of the first books to introduce the concept of financial independence to mainstream audiences, and while the concepts presented in the book about budgeting and retirement were revolutionary and still relevant today, the original edition’s advice about investing was not useful to modern audiences, as it boiled down to simply “Put all your money into government bonds and don’t bother with the stock market at all.”
The reason for this is that at the time of Your Money or Your Life’s original publication, government bonds were yielding north of 15%. And not only that, interest rates were going to begin a long, sustained downward trajectory. This had the effect of making bond prices go up, as those government bonds paying that nice, juicy 15% interest rate were suddenly more desirable in an environment when investors were lucky to get anything north of 4%. So that investment advice turned out to be spot on for the time.
That’s because there are 2 major macroeconomic factors that affect how attractive bonds are. Namely, their current yield and the direction of future interest rate moves by the central bank.
When yields are low and interest rates are on a rising trajectory, it makes sense to reduce your bond holdings and shorten their durations by switching to a short-duration bond fund like BSV (US) or ZSB (Canadian). This will reduce the damage that rising interest rates have on your portfolio, like right now.
Conversely, when yields are sitting at higher levels and interest rates are neutral, you should increase your bond holdings and pivot back to an intermediate bond fund like BND (US) or VAB (Canadian). This is because not only will you be able to lock in a higher interest rate on the fixed income side of your portfolio, you may even get a capital gain if the central banks decide to drop interest rates in the future.
It’s All About the Timing
The big $1,000,000 question, though, is when is it a good time to pull the trigger? When should we sell off our short bonds and re-invest back in the aggregate bond index tracked by the ETFs BND (US) or VAB (Canadian)?
The short answer is: When interest rates stop rising.
Now normally, interest rate moves are just as impossible to predict as stock market moves. And as a passive investing evangelist, I have been teaching that the best way to invest is to not try to predict anything and trade as if the news doesn’t matter.
And I still believe that.
However, over the last 2 years, I’ve realized that when it comes to the bond market, there are a few scenarios in which it is possible to predict the future direction of interest rates with a reasonable amount of certainty.
The first is when interest rates hit zero. Neither the US or Canadian central banks subscribe to negative interest rate policy, and that means that once interest rates hit the floor of how low they can go, they can only go in one direction after that: Up.
The other, I believe, is when interest rates are rising for a very specific reason and that reason goes away. We know why central banks are raising interest rates: to combat high inflation.
So all we have to do is wait for inflation, which is reported to the public by the government a few weeks before each central bank announcement, to fall with the target range of 2%-3%. At that point, the central bank will likely stop their hikes, and that’s when I’m planning on moving back to the intermediate-duration bond index, indicating that I no longer have a strong opinion on the future direction of interest rates.
Again, I have no idea when exactly this will happen, but you can bet I’ll be watching inflation indicators closely over the next few months. And as always, before I make any major decisions about our investing strategy, I will disclose it on this blog so that you can follow along if you think I’m right, or mock me incessantly if you think I’m wrong.
So that’s my strategy for our portfolio’s bond holdings. Wait until inflation falls back to normal, and when that happens, sell my short bond holdings, and buy back into the “normal” bond index ETF.
Depending on where interest rates settle, I may even change my portfolio allocation back to a more balanced fixed income allocation. I mean, if I’m looking at bonds yielding 10% or something like what Vicki had, you bet your ass I’m loading up on those puppies.
What do you think? Did you do anything different in your bond holdings this year? And if so, what are your plans for the future? Let’s hear it in the comments below!
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