Fixed Income: New Game, New Rules

Why I’m making some changes to my fixed income strategy.

For many years, my core fixed income strategy was two-pronged:

• Own high quality fixed income ETFs such as those following the U.S. Bloomberg Aggregate Bond Index.
• Buy CDs directly from banks and credit unions that pay more than Treasury bonds and have small early withdrawal penalties that act as an option to break the CD if rates did rise.

But bonds and bond funds have performed horribly so far this year. As of March 22, the Vanguard Total Bond Market ETF (BND) has lost 6.30%, while the iShares Core U.S. Aggregate Bond ETF (AGG) is down 6.15%. Both figures are total returns including dividends reinvested. Bonds declined as interest rates increased.

This dismal performance comes at a time when we need bonds to act as a shock absorber more than ever, as U.S. and international stocks are down a similar amount and a possible Putin bear lurks. Stocks and bonds also did poorly in the early 1980s when stagflation hit both asset classes.

Looking at past volatility in high quality bonds and the performance so far year-to-date, the loss on the bond funds has already exceeded two-standard deviations, which should happen only once every 20 years. By comparison, a two-standard deviation loss in U.S. stocks would be a loss of over 26%—easily in bear territory.

Still, let’s have a little perspective. Sure, rates have gone up recently, but rates can’t decline forever, and we don’t know whether the recent increase shown in the chart below is going to continue. If you think you do, then you know more than the nation’s top economists who have called the direction of rates correctly well under 50% of the time, which is less than that of a coin flip.

Shift In Strategy

While I still don’t know the future of intermediate- and long-term Interest rates, there are some things I do know.

• The yield curve is very steep in the first few years and then levels out, as shown in the illustration below.
• Banks and credit unions are paying low rates compared to bonds and Treasury notes.

Thus this argues for a shift in strategy—or at least a partial shift. Today, BND is yielding about 2.34% with a duration of 6.8 years, and AGG is yielding 2.19% with a 6.6-year duration. Though both will likely always be my core bond funds, it may make sense to sell some and buy a shorter-term Treasury like the two-year T-note yielding 2.17%, which is also state tax-exempt. This is especially compelling if you have a loss in a bond fund in your taxable account and can harvest this tax loss.

Treasury Yields At Fidelity On 3/23/2022

You get virtually the same rate after taxes with less interest rate risk and even less default risk. Could this backfire? Absolutely. If rates go back down again, we will wish we had some longer-duration holdings. That’s why I’m keeping the majority of my intermediate total bond funds.

I’m recommending buying the Treasury bonds themselves instead of funds for a few reasons.

The first, and most important, is that the short-term Treasury ETFs own a significant amount of very short-term Treasury bonds that pay very little. For example, the two month is yielding 0.2%. Accordingly, the iShares Short Treasury Bond ETF (SHV) is yielding 0.39% with a 0.33-year duration, while the Vanguard Short-Term Treasury ETF (VGSH) is yielding 1.60% with a two-year duration.

Second, while it’s incredibly important to diversify with non-U.S. government bonds via funds, it’s not so important on U.S.-backed government debt. That’s because the rest of our portfolio would fail if the U.S. government went out of business, as well as the fact that Treasury bonds, unlike most others, are very liquid, without high bid/ask spreads or commissions.

I previously noted that, until recently, I could earn more with less risk by buying direct CDs (not brokered CDs) from banks and credit unions with low penalties. Not only have rates not kept up, but I’m beginning to exercise my first option in the way of paying a penalty to get out of a CD.

I just closed a CD paying only 1.29%, paying a penalty of 0.64% to buy a Treasury bond yielding about 0.80 percentage points more. The breakeven is less than a year. The rule of thumb I tell people is to break the CD whenever you can earn more than twice the penalty of the new bond or CD over the remaining term of the CD.

Conclusion

The game has changed a bit, and that can call for doing things differently. What hasn’t changed is my recommendation that fixed income always be of very high credit quality, and that a bond fund has less risk in a year than stocks do in a week, or possibly a day.

Admittedly, the current year-to-date losses on high quality bonds aren’t good. Yet how quickly we forget the recent past, when U.S. stocks lost 11.4% on one day (March 16, 2020) and the 35% loss over the 33 days ending March 23, 2020.

While I may be tax-loss harvesting some of my bond funds, I’m not abandoning them. And when banks and credit unions catch up and surpass market rates, I’ll be recommending direct CDs again.

Allan Roth is the founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for Barrons, AARP, Advisor Perspectives and Financial Planning magazine. You can reach him at [email protected], or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter.