This year, interest rates have increased dramatically, leading to significant declines in bond prices. You may be most aware of this if you own a bond mutual fund or ETF. The share price of most has declined, and in many cases, the percent decline is in the double digits. Here, for example, is the performance of a well know bond ETF, the Vanguard Total Bond market ETF (Ticker BND). This particular ETF is structured to track a major bond index, the Bloomberg US Aggregate, an index that includes investment-grade taxable US binds.
The total return for that ETF is -14.36% YTD (Source: Morningstar, through mid-October 2022). That is a stunning decline for an asset class, bonds that are supposed to provide stability to one’s portfolio. Recovering from that decline may take years. At the current yield for the fund slightly over 4%, it will take over three years to break even if there is no further decline or if the fund’s share value does not recover. A problem for bond mutual funds is the redemptions. To raise cash to provide liquidity for the redemptions fund, managers tend to sell the assets that declined the least, usually the highest quality holdings. That could cause the remaining shareholders to own a fund with reduced quality meaning it is more likely the decline will not be offset with a gain anytime soon. ETFs are not subject to this issue shares are traded to another person instead of being redeemed by the manager.
The chart below which includes several yield curves showing how rates have changed over the last five years:
As you can see, rates have increased significantly over the last year due to the Federal Reserve raising the federal funds rate. The current yield curve is “inverted” shorter-term rates are higher than long-term rates. That was a sign we could be nearing a recession in the past. Unfortunately, rates on treasuries are not favorable when compared to inflation. The current yield on ten-year treasuries is almost 5% below the current inflation rate:
In the past (at least in the 1970s), there was a lag as the ten-year treasury gradually caught up and exceeded the inflation rate providing an actual positive yield. Whether that will happen again is anyone’s guess.
Yields on municipal bonds have also increased significantly over the last year, providing a reasonable rate of return, adjusted for one’s tax bracket, as evidenced by the chart below:
As seen from the graphs, the yield on municipal bonds of high quality is now the taxable equivalent of 4.3% and 5.2%, respectively, if you are in federal marginal tax brackets of 24 or 37%. Those are the highest yields we have seen in years. (You calculate Taxable equivalent yield or TEF by dividing the nominal rate by 1- your marginal tax bracket.
In conclusion, for the first time in years, bonds will provide some decent yield. We hope that inflation subsides, but fixed-income yields remain at reasonable rates.
We created a video with Dr. Mattia and Steve Craffen that covers this in some more deatil, you may find the video on our YouTube channel:
The video that accompanies this blog is here: