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Are Bonds Back in Favor?                                                                                               Join our Quarterly Newsletter          July 2023                                                                                             

Mark R. Hoffman

CEO, Principal

For decades, bonds were a great investment.  Beginning in the early 1980’s when the 10-year US Treasury was yielding over 15% (unbelievable, but true), interest rates dropped. And they dropped for 40 years.  All the way up to 2020 when they couldn’t decline any further without heading into negative interest rate territory.  Over those 40 years, if you had invested your money in bonds, you would have made 7-8%/year.  That’s a pretty great diversifier in an investment portfolio.

Bonds 101:

A quick aside for anyone that isn’t overly familiar with bond investing – and I will greatly simplify to keep it short.  If you have significant experience doing so, please skip this section! 

  • In a portfolio, there are two primary ways to invest in bonds. You can either buy actual bonds or you can buy bond funds that hold baskets of bonds. 
  • If you buy actual bonds, you can either:
    • hold them until they mature, receiving regular interest payments followed by a return of your principal at maturity, or you can
    • hold them for a while and then sell them on the open market, receiving regular interest payments while you hold them and a return of some portion of your principal based on the market price of the bonds at the time that you sell them.
  • When interest rates are rising, the market price of a bond will fall (the reverse is also true). Why is that?  If you buy a bond that has an interest rate of 5% and the next day the rate on bonds goes to 6%, who would want to buy your bond from you?  They would only do it if you gave them a discount on the price.  Otherwise, they would simply buy the newly issued bond that is paying a higher rate. 
  • If you buy a bond and hold it all the way to maturity, you are indifferent to interest rates going up or down. You have a set interest payment and you will receive your principal back at the end.  There will be a market price for that bond, but if you aren’t going to sell it, the market price is irrelevant.
  • If you buy bond fund, you will receive periodic interest distributions based on the yields of the bonds in the fund’s basket. But you will also take interest rate risk on the market values of the bonds in that basket.  Bond funds have to “mark to market” every night.  If interest rates go up, those bonds are marked to market at a lower price and the share price of that fund goes down. (If interest rates go down, those funds’ share prices gain in value as the underlying bonds mark to market at higher prices.)

How significant is this?  In 2022 when interest rates were going up, the bond market (as measured by the Barclays Aggregate Bond Index) lost 13%.  Anyone holding bond funds as their “safe haven” got hurt badly.


Portfolio Implications 

When the 10-year Treasury rate approached zero in early 2020, the logic of holding bonds as a portfolio diversifier changed.  Interest rates could only go up and as a result, returns from bonds could only go down.  If you bought an actual bond at that point and held it all the way to maturity, you were locking in a very low interest rate and therefore a very low return for that portion of your portfolio.  If you bought bond funds, it was even worse – very low interest rates and falling bond prices.  Very poor returns for bond funds.  Because of this low bond return dynamic, our portfolios at Lanier Asset Management saw bond allocations drop to all time lows.  

Fast forward to today.  Since early 2020, interest rates have gone up.  And they have gone up a lot.  They may go up even further if inflation persists.  So the logic for buying bonds in a portfolio has changed significantly again.  For years we at Lanier wouldn’t buy any bonds for our clients’ portfolios.  For the last 6-12 months, we have been buying a bunch of them.  

Please note that we are very careful with which bond investments we buy.  We still dislike bond funds, as the Fed may raise interest rates a few more times before they are done.  We are also concerned that if the economy tips into recession, there may be bankruptcies so corporate bonds come with their own set of risks.  But 3-month and 6-month US Treasuries?  Love them.  In January of 2022, the 3-month Treasury was paying 0.1%.  Today, it’s paying 5.4%.  And those are “risk-free” returns. 

We aren’t saying that a 5.4% 3-month Treasury is right in everyone’s portfolio.  But it certainly is WAY more attractive than it was a few months ago.  So are bonds back in favor?  We believe that for many portfolios, they are.

Mark is a co-founder of Lanier Asset Management and serves as its Chief Executive Officer. Prior to founding Lanier, he was a partner at The Boston Consulting Group. Mark is an honors graduate of The University of North Carolina at Chapel Hill with a BA in Economics, and holds an MBA from The Harvard Business School.