Bonds are supposed to be boring and provide returns with reassuring regularity. But many bond investors have had a troubling experience recently.
For several years, bond prices have fluctuated like an out-of-control roller coaster, and holders of bond mutual funds and exchange-traded funds have had an exceptionally stressful ride.
Bond prices and yields, or interest rates, are moving in opposite directions, and with interest rates falling this fall, there is actually good news for bond investors. So far this year, the benchmark for investment-grade bonds, the Bloomberg US Aggregate Bond Index, has achieved a return of more than 7 percent including dividends.
But that performance didn't rely on the Steady-Eddie reliability that bond experts once prized. It's just that the rollercoaster slipped into calm territory for a while, an abrupt reversal after the steep decline triggered by President Trump's tariffs in April. I doubt it will last.
To be clear, even if prices fluctuate wildly, just holding on to high-quality, individual investment-grade bonds until maturity won't hurt you financially. Individual bondholders generally receive back all of the money invested in high-quality bonds, plus any interest payments, when the bonds' term expires.
However, if you own bond mutual funds or exchange-traded funds, like most individual U.S. investors, fluctuating bond prices can be psychologically stressful, even if you don't sell the funds. This is because funds are required to report fluctuating prices every day.
Additionally, fluctuating fund prices are roughly equivalent to what individual bond owners would experience if they sold their bonds. They would be subject to the whims of the bond market, which was sometimes unforgiving.
I feel uneasy
In recent years, since the chaos of rapid inflation in 2022, it has become easy to lose large portions of your investments in bonds over certain periods of time. The Bloomberg US Aggregate, the most widely used benchmark for investment-grade bonds, including Treasuries, has lost more than 13 percent this year, including reinvested interest.
Things were even worse for 20- and 30-year U.S. Treasury bonds, which seemed to represent perhaps the pinnacle of safety. In 2022, the iShares 20+ Year Treasury Bond ETF, which tracks and holds long-term Treasury bonds, lost more than 31 percent of its value, about 13 percentage points worse than the S&P 500's negative return.
For bondholders, the pain remains. In the five years ended Oct. 20, the core Bloomberg US Aggregate fell 0.1 percent on an annual basis – a small loss, but compare that to the S&P 500's 16 percent annual gain. Longer-term Treasury bonds performed terribly over the same period: The iShares 20+ Treasury Bond ETF lost 7.7 percent on an annual basis, for a cumulative loss of 33 Percent corresponds to FactSet.
In other words, if you had held that long-term Treasury fund for those five years – or held equivalent individual Treasuries and sold them at the wrong time – the value of your bonds could have fallen by a third.
April saw another surprising drop in bond prices. “People were getting a little uneasy,” President Trump said on April 9, explaining why he was moderating his tariff policy, at least temporarily. “The bond market is very difficult,” he said.
It's also immensely powerful – paradoxically for an institution whose central appeal is the implicit promise that its main attraction will be boringly safe.
Reservations and concerns
The US bond market is not just a place to park money and collect interest. One area of this, the treasury market, is arguably the core engine of the entire financial universe, around which everything else revolves.
If you are an American consumer, the interest rates on your credit cards, mortgages, and auto and student loans are influenced by the bond market. If you are an investor, the entire stock market is evaluated using interest rates in the bond market as a benchmark. And for small businesses, large corporations and governments around the world, the treasury market represents the standard by which everything else can be measured.
Today, however, there are plenty of problems at almost every level of the market, starting at its core with U.S. Treasury bonds. The shutdown of government funding hurts the economy, but even if it ends soon, it will likely help the U.S. government's reputation.
After countless closures and debt crises, the rating of US government bonds is no longer top-notch in the eyes of any of the major rating agencies. The so-called risk-free Treasury is tarnished.
“Of course, you can’t say with a straight face that it’s risk-free,” Aswath Damodaran, a finance professor at NYU, said in an interview.
The gradual loss of the original status of government bonds has increased the yields that must be paid in the market. These higher returns increase the burden on future taxpayers and increase costs for businesses and consumers.
From the perspective of bondholders, the biggest problem may be that the government is spending far more than it takes in, and the federal debt as a percentage of gross domestic product has reached levels not seen since the end of World War II. The Trump tariffs bring in revenue, but are not enough to reduce the growing budget deficit.
At the same time, the government is pushing the Federal Reserve to lower short-term interest rates controlled by the central bank, threatening its independence. The possibility of another outbreak of high inflation cannot be dismissed.
If inflation rises again, most bond prices will fall as yields rise. To protect against this risk in the United States, Treasury Inflation-Protected Bonds (TIPS) are one solution, although they have not performed well in non-inflationary periods.
However, bonds tend to underperform when prices rise quickly. And the threat of higher inflation is weighing on the entire bond market.
Core holdings
However, high-quality bonds are still an essential investment for many people. US government bonds continue to be a key investment position for investors outside the USA.
The latest official government statistics – less current than they might be due to the government shutdown – showed that foreign ownership of U.S. Treasury bonds hit new highs in July. Specifically, what increased was ownership of Treasury bills—short-term securities with maturities of one year or less—rather than longer-term government bonds.
That may be because falling longer-term Treasury bond prices in recent years, coupled with the weakening dollar, are causing some international investors to worry about long-term holdings in the United States.
Domestic investors should also be careful. I shortened the duration of my own holdings last year, opting for easy access and safe assets at a time of looming crises. But I still own a lot of investment-grade bonds of various types through bond funds, and hold my shorter-term fixed income instruments – Treasury bills and the like – primarily in government money market funds.
I prefer owning funds over individual bonds because bond funds, especially low-cost index funds, provide broad diversification and are inexpensive and easy to use. Over long periods of time, bond funds and high-quality individual bonds tend to converge in value. If you don't need to sell the funds or individual bonds, the fluctuations won't be a big problem as long as you can handle falling prices.
I hold the bond funds primarily to mitigate the risk of my global equity index funds, which fluctuate more than the bond funds. The data provided by Morningstar backs this up.
Morningstar used returns for the S&P 500 and its predecessors as well as for 10-year Treasury notes from 1928 to 2023. It found that including Treasury bonds in a stock portfolio significantly reduced the likelihood of overall portfolio losses over periods of 10 years or less.
In a risky time, it still makes sense to hold safer assets, and that still means bonds. But don't kid yourself. The rollercoaster will definitely start to lurch again. These days, even government bonds are not entirely safe.