The U.S. bond market lost -1.5% in 2021 as measured by Barclay's Aggregate Bond Index. With the Federal Reserve hinting at rate increases in 2022, the year ahead might not look much better. So with yields low and rates projected to rise, why should I own bonds?

Bond Math

As an asset class, bonds have less risk for loss of principal than all other asset classes except cash. So then, how did they lose money in 2021 when all other asset classes made money? The answer is the rise in interest rates.

If you bought the average bond on January 1, 2021, it yielded about 1.3%. On December 31, similar bonds were now yielding 1.8%. To an investor, your bond that yields 1.3% is worth less than the 1.8% bonds. As a result, the value of your bond takes a hit. If you sold it today, you would lose some money. Note that if you hold the bond until maturity, you will still earn 1.3% per year on average. Those investors who waited until December to buy the same bond will average 1.8%, albeit for one less year.

A bond's interest rate sensitivity can be measured by duration, which is the bond's maturity adjusted by the cash flows over its life. The current duration of the bond market is about seven years. If interest rates rise by 1% over the coming year, the bond market will lose 7% in value but still earn 1.8% of income. Therefore, the total return for one year would be a loss of -5.2% (1.8% less 7% = -5.2%). If you know that interest rates are increasing, buying bonds after rates rise would be beneficial. You avoid the loss of -5.2% and buy a bond that yields 2.8%.

What the Federal Reserve Controls

The Fed is signaling 3 to 4 interest rate increases in 2022 for as much as 1%. It is important to note that the Fed would be raising the Federal Reserve Discount Rate, not the U.S. 10-year Treasury or a 30-year mortgage. The discount rate directly impacts variable borrowing rates such as the prime rate, but it does not directly impact bonds, such as mortgages. Since investors mostly own Treasuries, mortgages, and other bonds not tied to the discount rate, most bonds are not directly impacted by the Fed's increases.

However, the Fed can directly impact these bonds through bond transactions. By buying or selling bonds, the Fed affects the prices of bonds, which causes the yields to move lower (when buying) or higher (when selling.) With the Fed buying fewer bonds and potentially selling bonds, there will at least be less downward pressure on rates and possibly upward pressure on rates.

The bond market doesn't wait on the Fed. Before the Fed even announces decisions, economic forecasts can often predict these actions, and the bond market will move in anticipation. As a result, it is possible (though extremely difficult to say with certainty) that the bond market is already reflecting 3 to 4 rate increases. In this scenario, buying the 1.8% bond will yield a total return of 1.8% because rates did not move after the Fed decisions. Holding cash for a year and earning close to 0% could be a poor investment.

Other Investment Options

Cash is always an investment option, but pays close to nothing for now. If you don't want to own bonds or cash, the other options are riskier investments such as real estate, stocks, commodities, currencies, etc. Most of these other investments have had strong performances over the past few years. There is a very good possibility that returns in riskier asset classes will be lower than their recent returns in the next few years. They could even experience losses.

I don't know if riskier assets will do well in 2022. But, in the long run, I think they are an important part of a long-term growth strategy. However, adding to these investments now increases the overall risk in your portfolio at a potentially inopportune time.

Back to Bonds

This brings us back to bonds. They are safer than most other asset classes and higher-yielding than cash. If you don't want to own interest-rate sensitive bonds, shorter-term bonds carry less interest rate risk (offset by lower yields). Higher-yielding bonds are also available, provided you are comfortable with their unique risks.

Owning bonds today is still relevant because they provide steady income and protect portfolios when risky assets fall. If you rely on your portfolio for spending, the bond portion should protect your spending level. And, you can sell bonds and take advantage of lower prices in risky assets. If all of your money is in risky assets when they fall, you would be unable to "buy low."

Summary

Regarding the role of bonds in your portfolio: how much you should invest and what types of bonds are appropriate are great questions to consider. Again, do your research and ask your advisors before making any changes.

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