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For Dr. James M. Dahlefounder of WCI
Sometimes I write blog posts that I want to write. Other times, I write blog posts that Josh (our content director) and Lauren (our Director of Digital Marketing and Search Engine Optimization Guru) want me to write. This is one of the latter. Apparently, a lot of people are searching the internet right now for the answer to this question. Here are some possible answers to the title question:
You shouldn’t have stopped shopping bond fund. I didn’t stop buying bond funds. I’m still buying bond funds. Bond funds are more attractive now than they were a year ago, but they could be even more attractive in another year. Yes. No.
Okay, now that I’ve done that, I can write whatever I want.
Bonds move inversely with interest rates
Perhaps the most important thing to understand about bonds is that when interest rates go down, the value of a bond goes up. The reason is that your bond that pays interest at a higher rate is now more valuable than a bond that can be bought today that pays interest at a lower rate. How much more is your bond worth? Precisely the amount that equalizes the yields of the two bonds with different interest rates.
Naturally, when interest rates rise, the value of bonds falls for exactly the opposite reason. Who wants that crappy old one that pays 2% when I can get a shiny new one that pays 4%? I’m not buying your old one unless you sell it to me at a discount.
Bond fund Own bonds
A bond mutual fund is simply a convenient, liquid and diversified method of holding bonds. If you choose wisely and select a diversified and very low cost bond fund such as those available from Vanguard—Get all this convenience, liquidity and diversification for free (along with some professional management). This is very big.
However, a bond fund is not exactly the same as holding an individual bond. When you have a high-quality bond, such as a Treasury bond, there is a guarantee. You’re guaranteed to get all of your principal back eventually, plus interest along the way. With a regular Treasury bond, your nominal principal is guaranteed. With a TIPS, your actual principal is guaranteed. This guarantee does not exist with a bond fund. Because a bond fund is a pool of bonds that is continuously restocked, it is possible to lose principal in a bond fund. However, in the long run, this really isn’t a particularly significant risk. Also, what do you think you’re doing when you’re building a portfolio of individual bonds? That’s right, you’re managing a bond fund. Your only real advantage is that you are not subject to the tax consequences of the actions of the other investors in the fund.
More information here:
I Bonds and TIPS: Which inflation-linked bond should you buy now?
Higher interest rates are good for bond investors
Here is a principle that few investors understand. If you’re a bond investor, you really want interest rates to go up. Yes, that means all your bonds have lost value. But it also means that the expected future returns on your bonds are now much higher. Over the long term (defined as any time period longer than the duration of the bond fund or your bond portfolio), you will come out ahead. So, unless you’re 90 years old with a collection of 10-year bonds (and I hope you’re not), stop complaining about rising interest rates. It makes you look silly. If you are a future net saver and not a future net borrower, all things being equal, higher interest rates are a good thing.
More information here:
Why bother with bonds: a review
You need an investment plan or a crystal ball
As an investor, I learned early on that my ability to predict the future is not good enough to rely on for investment decisions. In short, my crystal ball is always cloudy. It probably is too, but if you’re still not sure, I suggest you do an exercise. Write down all your predictions in a little $2 journal that you can buy at Target. You know, things like what’s a stock going to do, what’s the market going to do, what interest rates are going to do, what asset class is going to outperform over the next, two, five, 10 years, and so on. Make these specific predictions. Continue for a year or two. Chances are you’ll find that your crystal ball is just as cloudy as mine. If you find it isn’t, you should consider opening a hedge fund, managing billions, and getting paid 2 and 20.
The problem with a question like “Should I start buying bond funds again?” is that the answer requires a working crystal ball. What you’re really asking is, “Will interest rates stop going up?” The answer to that is, “I don’t know.” Actually, I think a more accurate answer is, “I think they’ll probably go up at least one more time, but I have no idea what’s going to happen next.” The reason I say this is that as I write this on October 28, 2022, I can read latest statement from the Fed’s Open Market Committee starting in September 2022. In September 2022, the Fed raised the “effective federal funds rate” from 3 to 3 1/4. The average view of committee members at the time was that by the end of 2023 this rate would be 4.6%. This suggests that there will be more rate hikes ahead of us.
Now, just raising the very short-term federal funds rate doesn’t mean that the interest rates that affect our lives the most, like the 10-year Treasury rate and the 30-year mortgage rate, will go up. The yield curve is currently inverted, suggesting a potential recession is on the way. But it seems more likely than not that rates will have to rise at least a little more. However, I really don’t think they need to go much higher to control inflation. The reason is that the latest data suggests that it already is.
Most people look at year-on-year inflation data. But there is current data that is released every month. Here’s what it’s showing right now:
As you can see, we’ve had nasty inflation over the past year. Check out these February, March, May and June issues. This is bad. A monthly inflation rate of 1.37% per annum is close to 18% inflation. But look at the last three months. There is a negative number for two of them (namely deflation), and the September number is annualized around 3%, not far from the Fed’s annualized 2% target. This suggests to me that we may be starting to get inflation under control. Undoubtedly, these higher interest rates have already had a big effect on housing. In my area, the median home price is already down more than 7%, and home prices are notoriously sticky. I just don’t think they need to raise rates too much more to control inflation, which is the goal.
Of course, remember what I told you about my crystal ball. Although I have an opinion, I am smart enough not to rely on it for my investment decisions.
Since neither you nor I have a working crystal ball, I suggest you do what I did and develop an investment plan this does not require you to successfully predict the future to be successful. This plan is a static asset allocation. I have 60% stocks, 20% bonds and 20% real estate. When interest rates are high, I hold 60% stocks, 20% bonds, and 20% real estate. When interest rates are low, I hold 60% stocks, 20% bonds, and 20% real estate. When interest rates rise, I hold 60% stocks, 20% bonds, and 20% real estate. When interest rates go down, I hold 60% stocks, 20% bonds, and 20% real estate. Do you get the photo? Do you see how it works? Sometimes my shopping is well timed. Sometimes it’s poorly timed. But in the long run, I got rich and I will stay rich.
My own bond purchases over the past two years were made in:
01/25/21 02/09/21 02/16/21 06/21/21 07/26/21 11/21/3/21 12/13/21 01/22/22 01/31/22 04/18 /22 04/21/22 07/05/22 08/09/22 10/12/22
Some of them were Individual bonds I or TIPS purchased from Treasury Direct, but most were bond fund purchases. I don’t buy bonds every month, but it would be an unusual quarter if I didn’t buy any bonds. Does this sound like the investment record of someone who can predict the future? Or does it look like the investment record of someone who keeps buying while making money? bingo You got it. How Nick Maggiulli likes to say (paraphrased):
“‘Just Keep Buying’ Is the Secret to Long-Term Wealth Accumulation.”
Now, you know why I answered the title question the way I did.
what do you think Do you try to time the market when you buy bonds or just keep buying? Has rising interest rates affected your decision to buy individual bonds or bond funds? Comment below!
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