US Bonds are on pace for their worst year in history, down over 11% year-to-date.
On a monthly basis, this is now the longest US bond market drawdown ever (25 months and counting) and the largest (-12.3%) since 1980.
Why are bonds falling? Interest rates are rising at a rapid rate from historic lows, and bond prices move inversely to interest rates.
But not all bonds are equivalent. The higher the duration, the more a bond will benefit if interest rates fall and the more it will suffer if interest rates rise. For much of the past 40 years, duration was the best friend of bond investors as interest rates fell from record highs in the early 1980s. But in 2022, it has become their worst enemy.
The correlation between duration and year-to-date returns in this table of popular bond ETFs: -0.92.
While short duration Treasury Bill ETFs (ex: $BIL, 1-3 month treasury bills) have held up well, those with longer durations have been absolutely crushed. The longest duration bond ETF ($ZROZ) is now down over 46% from its high, more than 3x the current drawdown in the S&P 500 (-14%).
Needless to say, fixed income investors aren’t accustomed to such declines as bonds tend to be synonymous with safety. This mismatch between expectations and outcomes is undoubtedly leading some investors to sell in panic, abandoning their asset allocation plan.
Which begs the question: is there there a way to earn bond-like returns without the risk of drawdowns?
As it turns out, yes, in the sleepy and rarely discussed world of certificates of deposit (CDs). The highest yields on various CDs today (from 1 year through 10 years) are actually above the current yield on the Aggregate Bond ETF ($AGG, 3.42% 30-day SEC yield).
And importantly, you are incurring less risk in a CD than a bond fund, because CDs come with FDIC insurance of up to $250,000 (per account/depositor/account type). And unlike a bond fund, an investor in a CD will not see any principal fluctuations during the holding period. The principal balance only goes up with each interest payment until maturity.
So what’s the catch? Why doesn’t everyone just buy CDs instead of bond funds? A few reasons might apply…
If you don’t want to hold your CD until maturity, you will have to pay a penalty to get your money back, often 3 months of interest but can be higher or lower depending on the bank/maturity.
With a bond mutual fund, you can sell at the end of each day with no penalty and with a bond ETF you can sell intra-day.
A CD requires some effort in finding the bank with the best interest rate, opening up a new account, and making sure you don’t go above the FDIC limit (if you want to eliminate any credit risk of the issuing bank). When a CD comes due, many have the option to automatically renew at the same term at whatever the latest rate is, but if you want to shop around for the best rate, you will have to repeat this process all over again.
By comparison, the effort in purchasing bond ETFs/funds is minimal and requires no maintenance.
If you live in a high tax state, buying Treasury bond ETFs or funds with similar interest rates may be preferable as the interest on federal government bonds are generally exempt from state and local income tax.
By comparison, CD interest is fully taxable at the federal and state level.
4) Rising Interest Rates
If interest rates rise, you won’t see your principal decline in a CD like you would in a bond fund, but you will be locked into that lower yield until your CD matures. While there are “bump-up” CDs that give you the option of moving interest rates up (typically once) during a term, they often come with lower starting yields.
5) Falling Interest Rates
If you think interest rates will decline significantly from here and want to profit from that view, CDs are not the right vehicle. While CDs were earning little interest in 2019-2020 during a period of sharply falling interest rates, the Aggregate Bond ETF ($AGG) rose 8.5% in 2019 and 7.5% in 2020.
Is there a way to mitigate liquidity and interest rate risk?
Yes, you can create what’s known as a CD “ladder,” where you break up your total investment into various maturities (ex: 1-year, 2-year, 3-year, 4-year, 5-year) and when the shortest maturity comes due (1 year in this case) you reinvest at the longest duration (5 years in this case). This will give you access to a portion of your funds every year and if interest rates rise you can reinvest that portion at a higher rate.
The trade-off? At least initially, you will often be accepting a lower portfolio yield than if you simply put everything into the longest maturity option. And if interest rates fall, you will be reinvesting interest payments at a lower interest rate.
What’s the Best Choice for Fixed Income Investors?
Ultimately, whether a CD is better for an investor than an aggregate bond fund will depend on a multitude of factors, many of which cannot be predicted in advance (most importantly, the path and magnitude of any interest rate changes).
However, for investors with little tolerance for drawdowns in the low-risk bond portion of their portfolio, CDs may be the better option if they intend to hold until maturity and don’t mind doing a little extra work. While the value of the certificate of deposit may go down when interest rates rise, the fact that investors cannot see that decline can be an important psychological benefit.
If you can stick with CDs because they always appear to be going up but cannot stick with bond funds because the short-term losses are transparent, that may be reason enough to own CDs. Even if the bond fund ends up with a higher overall return, if you couldn’t hold on along the way that fact becomes irrelevant.
The best investment strategy is not the one with the highest return (which is impossible to predict in advance) but the one you can stick with long enough to reap the benefits of compounding.
Related Post: How to Earn a Higher Return Without Taking More Risk
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