I know nothing gets people going like a newsletter about bonds. Please try to contain your excitement.
But I have been getting a decent number of questions lately from people wondering if they should be adding bonds to their investment portfolio. The main reason for these questions is that bonds are paying more now than they have in nearly two decades.
But before diving into bond prices and yields, let’s do a brief refresher on what a bond actually is.
In short, a bond is a loan. When you buy one, you’re lending money to a government or a company. They pay you interest along the way, then pay you back in full when the bond comes due.
The interest that you earn along the way is called a bond’s yield. And for most of the 2010s and into the 2020s, bond yields haven’t even kept pace with inflation, only paying anywhere from 2% to 3%.
However, with the government and big companies borrowing more money right now, inflation remaining sticky, and the Federal Reserve not being in any hurry to cut interest rates, lenders are asking to be paid more, and yields have gone up.
You can either buy a bond individually, or you can buy a bond index fund, which lets you own thousands of individual bonds in one purchase. Right now, “the Agg,” which is an index that tracks the whole U.S. investment-grade bond market, is currently yielding around 5.3%. And the 10-year Treasury (government bonds that mature in 10 years) is yielding north of 5% after falling below 0.5% earlier this decade.
Now, not to get too complicated here, but when yields increase, the price of existing bonds falls because you can now buy bonds that will pay you more money. This is why the last few years for bonds have been tough; with the rapid increase in interest rates, the U.S. bond market has fallen around 20% since 2020.
But today, you can buy bonds that will pay you 5% moving forward.
So should everyone be adding bonds to their investment portfolio?
As with any financial question, it depends on your situation and goals. If you’re simply looking for the highest potential return, history tells us that stocks are a better long-term investment. Here’s a graph from Dimensional showing the growth of $1 since 1926:
As you can see, over the past 100 years, stocks have far outperformed bonds, and it’s not even close. There is an opportunity cost to holding bonds or cash over time.
Nevertheless, there are some economic periods where bonds will outperform stocks, but it’s very rare. Ben Carlson put together the following chart showing the rolling 10-year total returns for the S&P 500 and 5-year U.S. Treasuries starting from the 1930s:
Stocks have beaten bonds over 83% of the time. And if you look at just the past 10 years, the S&P 500 is up over 300%, compared to a single-digit total bond return.
So what’s the point of bonds, then?
Well, as surprising as this may seem to people who just started investing in the past handful of years, stock values can go down. And when they do, bonds have performed quite well.
Here’s another chart from Ben Carlson showing all of the down years in the U.S. stock market along with the corresponding bond returns for those same years:
Since 1929, the S&P 500 has had 26 negative years, losing 13.5% on average. In those same years, 10-year Treasuries gained 4.3% on average. That’s an outperformance of nearly 18%.
In 2008, stocks fell 37% while Treasuries rose 20%. In 2002, stocks fell 22%, and Treasuries rose 15%.
The exception was in 2022, when both stocks and bonds declined together, but most of the time bonds are an awesome stock market hedge.
Bonds can also be helpful for short-term money you may need in a few years, like a house down payment or business purchase, where you don’t want to risk a 15% market downturn. Because stocks typically hold up in a market crash, having bonds to sell to purchase stocks on sale can be a good way for a diversified portfolio to buy low. Not to mention that bonds smooth out volatility in a portfolio, and a less volatile portfolio can be easier to stick with for the long run. And the best long-term returns come from staying invested.
Additionally, bonds can provide steady income for retirees. As you become less concerned with growing your portfolio and more focused on preservation of the assets you already have, bonds can play an important role.
But if you’re a long-term investor and still have decades to go before you’ll need your savings, bonds aren’t a replacement for stocks.
Given enough time, you can make the case that it’s actually riskier to keep your savings in bonds or cash than in stocks.
Thanks for reading!
Jake Elm, CFP® is a financial advisor at Dentist Advisors. Jake a graduate of Utah Valley University’s nationally ranked Personal Financial Planning program. As a financial advisor at Dentist Advisors, he provides dentists with fiduciary guidance related to investments, debt, savings, taxes, and insurance. Learn more about Jake.