Back in the 1980s, Michael Milken earned celebrity as “the junk bond king.” With his swagger—and his toupee—Milken was an outsized personality in a normally staid industry. But that was 40 years ago, and that may have been the last time that bonds were truly interesting. On most days, bonds are about as dull a topic in finance as one can find. But here’s the challenge for investors: While bonds might be boring, they’re important, and they can be tricky.
Consider the Vanguard Total Bond Market Fund. As its name suggests, it’s designed to offer a one-stop shop for bond investors. For that reason, total-market funds like this are one of the three pillars of the vaunted three-fund portfolio. They’re intended to be an easy, set-it-and-forget-it solution for any investor looking to add bonds to their portfolio. But these funds are far from perfect.
Just look at 2022. When the stock market was down—and thus, when investors would have benefited most from the relative safety of bonds—total-market funds lost about 13%. It’s too simplistic, though, to criticize these funds only because of their past performance. Instead, it’s worth looking under the hood to understand why they struggled. These were the key drivers:
Duration. The biggest driver of bond prices is a metric known as duration. In simple terms, it’s a measure of how long it would take a bond investor to receive his or her money back. Let’s look at an example: Suppose you own a bond that matures exactly one year from today. At first glance, you might conclude that the duration of this bond would be one year—because that’s when you’ll get your money back. However, because most bonds make periodic interest payments prior to maturity, you’ll end up receiving your original investment back, on average, a bit before the one-year mark. As a result, the duration of this bond will be a bit less than one year.
That might seem straightforward, but how does duration impact the performance of a bond? To understand this, suppose you wanted to buy a bond today. You have lots of choices. The first option might be a recently-issued Treasury bond that offers a 5.5% coupon (interest) rate. Alternatively, you could buy a two-year Treasury bond that was issued last year. In both cases, the bonds will mature one year from today. But because interest rates were lower last year than they are today, the coupon rate on the older bond will be just 4%. That will cause the older bond to be worth less. Why? Suppose the new 5.5% bond is selling for $1,000, which is the standard price for new bonds. If that’s the case, then you certainly wouldn’t pay the same $1,000 for the older 4% bond. You might still be willing to buy it, but only at a lower price.
What would be the right price for this older bond? Here’s how to think about it: You’d want enough of a discount on this older bond to make up for its lower coupon rate (4%), which is 1.5 percentage points below the 5.5% rate available on a new bond. The discount you’d want would be $15—because $15 is 1.5% of $1,000. So you should only be willing to buy a 4% bond today if you can get it for $985—in other words, $15 less than a new $1,000 bond.
A key point here is that bonds always mature at their “par value.” So even if you’re able to buy a bond for $985, you’d still receive the $1,000 when it matures next year. Thus, if you were to buy the older 4% bond for $985, then over the next year, you would make money in two ways: First, you’d receive the 4% interest payments. But in addition, at maturity, you’d pick up another $15. So in total, you’d make 5.5% on this bond—the same as you’d be able to earn on a newly-issued 5.5% bond.
That’s the basic concept behind duration, and it explains why older bonds decline in value when interest rates on new bonds rise. And that’s precisely what happened last year. In 2022, the Federal Reserve raised interest rates a total of 4.25 percentage points over the course of the year. This directly—and negatively—impacted the value of older bonds.
There’s one more element of duration to understand, and this is the most crucial for bond investors: The greater a bond’s duration, the greater the risk when interest rates rise. To see why, let’s look at another example. Suppose now that you want to buy a bond that matures in two years. You could buy a newly issued two-year bond with a coupon around 5%. Or you could buy a three-year bond issued last year. Again because rates were lower last year, that older bond will only pay about 4%. But both will mature at the same time, two years from today. Now how much would you pay for this older bond?
Following the same logic as above, you might be willing to purchase the 4% bond, but you’d want a discount. How much of a discount? In the example above, we calculated a $15 discount, because that’s what would be required to make up for the 1.5% gap in coupon payments over one year. But in this case, if there are two years to maturity instead of one, the discount will need to be greater. That’s because there will now be two years of lower interest payments that we’ll need to make up for. So in round numbers, the discount on this two-year bond would need to be twice the discount required on the one-year bond—$30, in other words, instead of $15. The key lesson: Duration is a critical driver of bond prices. And the longer the duration, the greater the price risk on a bond.
Composition. The bond market is very diverse. The US Treasury, of course, issues bonds. So do states as well as cities and towns. And corporations of nearly every stripe also issue bonds. At first glance, you might think that these differences would be an important factor in the performance of bonds. To be sure, they are a factor, but not nearly as significant as you might guess.
Consider, for example, how a set of popular bond funds performed in 2022, in the face of steeply rising rates. Vanguard’s intermediate-term corporate bond fund lost about 14%, while its intermediate-term Treasury bond fund lost about 11%. Meanwhile, its short-term corporate bond fund lost about 6% while its short-term Treasury fund lost about 4%.
What can you conclude from this? I see two key points: First, Treasury bonds tend to hold their value better than corporate bonds. That makes sense since—despite the political dysfunction in Washington—the US Treasury is still a safer bet than even the most stable corporation. That explains some of the performance difference between the two categories.
That difference is dwarfed, however, by the performance difference between short- and intermediate-term bonds. Short-term bonds, with their shorter durations, held up much better than their intermediate-term counterparts. And as you can see, even short-term corporate bonds held up better than intermediate-term Treasury bonds. Long-term Treasury bonds fared even worse, with many losing nearly 30% last year.
This is why, in structuring your portfolio, I would lean heavily on short-term bonds. Since interest rates are unpredictable, I see that as the best route to preserving value. And that’s why total bond market funds, despite their reputation for simplicity, aren’t, in my view, a great solution. The problem, as you can probably guess by now, is that the duration on these funds is quite long—similar to the intermediate-term funds referenced above. They might be appropriate for part of your bond allocation, but I’d make it just a small slice.