Disclaimer: This article isn't investment advice, just personal opinions.
Recently many friends asked me
I'm investing with 80% stocks and 20% bonds as advised by everyone else, or UPRO/TMF 55%/45%, but why does bond keep dropping? News clearly states bond yields have been going up, right？
Good questions! This on the surface is a typical question of "my portfolio is going down, should I sell?" and the answer to these type of questions is also usually No.
However, with the mindset of "it's different this time" ;) I dug deeper, but umm... this time it might actually be different?
Bond price vs yield
Surprise surprise! If yield goes up, price goes down.
ROI=return/cost. Here, the return is fixed, which is coupon rate by definition. The costs is more complicated. For example when a bond is issued (when FED is holding an auction) The text can be for example you lend Uncle Sam 100 bucks, in 10 years, you will be repaid 102 bucks. The yield will be 102/100-1=2%.
For now, the cost of 100 bucks is obvious, but after you bought the note in the auction, stock market has been performing very well, no one is willing to buy a bond with such low return rate. If you were to sell it, buyers for example are only willing to pay $98 to be repaid $102 in 10 years. The market value of the note now becomes $98 and the yield would be 102/98-1=4%。
Wait why isn't the cost what's defined in the text of the note？
This is because the bond you are holding is probably bought from secondary market, and will be resold to other people later before maturation. Or if you are holding bonds in a ETF, the price of your ETF is also calculated based on the market value of these bonds.
If you still don't understand, you can think of why a stock's price can jump so much after IPO. It's price in the primary market at first, and then market value in the secondary market after IPO.
This is why bond's yield or price is affected by supply and demand. If stock market is performing too well then not too many people is willing to deposit a significant portion in low-yield bonds. If in a down market like in 08, then bond is a no risk safe harbor, everyone is trying to get a bond, so price would go up if the yield is minimal.
How about interest rate?
If you follow news you might see news like "Fed increased interest rate by 0.1 points" . Interest rate is defined when issuing bonds. For example, for a $100 10 year T-note, 2% of interest rate means you will be repaid $102.
If interest rate climbs up, yield goes up, because in the formula of return/costs, return goes up. You think this would be a good news, right? Right??? Nope!
If you are holding bonds or bond ETF, unfortunately you will lose money... because you are holding the older notes, the ones before rate increase, not after. FED can't increase rate on bonds already issued, but only increase rate on new ones.
Congratulations, the bond you are holding just became less desirable and the price must be adjusted lower to have a similar yield level with recently issued bonds.。
Relationship with inflation
We just explained the supply demand and interest rate relationship with bonds, but what about inflation?
If inflation or the expectation of inflation is high, for example 4%. Then it would mean that if you don't make 4% a year on your portfolio, your wealth actually decreases. If the bond yield is 2% for example, then holding them will lose 2% and the price will keep plunging until the new yield makes sense for investors to buy them.
This also explains why long-term bonds are more risky than shorter-term notes or bills. Can inflation make 100 bucks worth only $50 in two years in the US? Probably no, but 30 years? Maybe.
But bonds can be used to hedge against stocks ... right?
Almost every institutes and people are advocating for portfolios with both stocks and bonds, and it's based on these two assumptions:
- Holding bonds in the long term will have positive returns.
- It's negatively correlated with the stock market.
This has been true for a very long time. Every time when the stock market crashed, bond will go up a lot.
However in the current market, BND is down 2-3% in 1 year, and TMF is down 32%. What's more concerning is the bond market and stock market has been having positive correlation for at least a year. A couple of the recent stock market correction was actually triggered by bond price decrease.
Why is this happening? I think this is because previously stock market drives the price of bonds, when stock goes up, bond becomes undesirable, and when stock market crashes, money flows into bonds. However the causality is reverted recently. The market is worried about inflation and the unstable bond market along with the FED not able to control it, so the stock and bond market might go down at the same time.
If your portfolio still has a huge allocation to bonds, I would sell some of them and holding cash for some time if you are worried about market downturns.