How to Endure the Big Decline in Bonds

It’s been a horrible start of the year for the bond market, the worst in decades.

If you hold bonds in a mutual fund or exchange-traded fund, it’s highly likely that your quarterly statement next month will show that you have lost money.

Last week, I wrote about the market rout and about the signals that the bond market may be sending about the state of the economy.

Many readers have asked for further explanation of what has happened and what, if anything, they should do about it. Here are some answers.

How bad are the bond market declines?

Really, truly, historically bad. The most important measure of the overall investment-grade U.S. bond market is probably the Bloomberg Aggregate Bond index. It was down 6.66 percent this year through Thursday.

How terrible is that? Well, Sébastien Page, the chief investment officer for T. Rowe Price, a major asset manager, saidthe overall bond market’s three-month performance is the worst since 1980. For Treasurys, it’s the worst three months since at least 1926, when comparable data began to be available.

“It’s definitely newsworthy,” he said. “This is no exaggeration.”

Does it make sense to hold bonds if they are losing money?

It may be painful to hold bonds now, but there are good reasons to do so, especially Treasurys.

Mr. Page, who is the author of the book “Beyond Diversification: What Every Investor Needs to Know About Asset Allocation,” said Treasurys are safe and provide insurance when stocks and other investments fall. “The expected return on bonds is low and they aren’t providing all of the benefits of diversification that they have in the past, but they will, I think, continue to deliver in a crisis, when you get an extreme flight to safety.”

Treasury Inflation Protected Securities (TIPS), which are designed to perform well when inflation is unexpectedly high, have done that job lately, he added.

Joe Davis, chief economist for Vanguard, said long-term buy-and-hold investors who own stocks and bonds through low-cost index funds are likely to prosper if they can stand the stress and hang on during this turmoil, and even keep adding to their investments through a regular plan.

“Diversification doesn’t protect you from all losses all of the time, but over the long run, if you hold stocks and bonds, diversification works,” he said. “Rising bond yields mean that you will be receiving more income from your bond funds in a few years, and that’s a very good thing.”

Will interest rates keep rising?

Short-term interest rates almost certainly will, because the Federal Reserve says so. It controls the federal funds rate, the rate that banks charge one another for overnight loans, which it increased by 0.25 percent on March 16, from nearly zero. The Fed has held rates extraordinarily low since the start of the Covid-19 pandemic in 2020 in an effort to jump-start the economy. Now, the Fed says it intends to keep increasing rates to combat inflation, which has gotten out of hand.

Prices increased at an annual 7.9 percent pace in February, as measured by the Consumer Price Index.And the March numbers are likely to be even worse when they come out on April 12.

What’s the risk to the economy if interest rates keep going up?

The Fed could set off a recession if it raises rates too high. Its own projections suggest that by 2023, it will increase the fed funds rate above “neutral” — the approximate level that neither stimulates nor slows the economy, said Sarah House, senior economist with Wells Fargo. The Fed estimates that the neutral level is in the 2.25 to 2.5 percent range. Once the fed funds rate goes above that, the economy will start to slow, or so economic theory says.

Rising prices are already hurting consumers, and the economy could already be slowing. Russia’s war in Ukraine has sent oil, food and other commodity prices rocketing.

Raising rates during a geopolitical shock is tricky. “The risk of a recession in the next 12 months is still below 50 percent,” Mr. Davis of Vanguard said. “But there’s no doubt that the risk is rising.”

What about other bond market rates? Are they rising, too?

Yes, other rates set by bond market traders have been rising sharply, especially those of shorter duration, partly in anticipation of further action by the Fed.

Look at it this way.The Fed has already told us it expects that within the next year or two, the fed funds rate will exceed 2.25 percent. So the yield on two-year Treasurys has roughly tripled since Dec. 31, rising to about 2.3 percent from 0.73 percent. Because prices move in the opposite direction from interest rates, the value of Treasurys has plummeted.

I keep hearing about “inversions” in the bond market. What’s that all about?

While the Fed has intervened extensively in the entire bond market, it has less influence over longer-term bonds — those for, say, five or 10 or 30 years. Their yields haven’t risen as rapidly as those for shorter-term securities. In fact, some shorter-term rates have already exceeded those for longer-term bonds. When that happens, as the jargon goes, there is a “yield curve inversion.”

Inversions suggest that traders doubt that the Fed will be able to keep increasing interest rates because the economic impact will be too severe.

Yield curve inversions sometimes, but not always, predict recessions. The signals so far are fuzzy, said Richard Bernstein, the former chief investment strategist for Merrill Lynch, who now runs his own firm, Richard Bernstein Advisors.

“The Fed has many options it can choose before we will be facing a recession,” he said, adding that he doesn’t expect a recession soon but does believe that inflation will remain fairly high. Mr. Bernstein, therefore, suggests that, in addition to bonds, investors should be holding assets that “tend to prosper in high-inflation environments, like commodities, real estate or certain kinds of stocks, like in the energy, materials or defense sectors.”

I own Treasury bonds directly, not through mutual funds or E.T.F.s. Have I lost money?

No, unless you sell the bonds, you won’t lose a cent.

Inflation F.A.Q.

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What is inflation? Inflation is a loss of purchasing power over time, meaning your dollar will not go as far tomorrow as it did today. It is typically expressed as the annual change in prices for everyday goods and services such as food, furniture, apparel, transportation and toys.

What causes inflation? It can be the result of rising consumer demand. But inflation can also rise and fall based on developments that have little to do with economic conditions, such as limited oil production and supply chain problems.

Where is inflation headed? Officials say they do not yet see evidence that rapid inflation is turning into a permanent feature of the economic landscape, even as prices rise very quickly. There are plenty of reasons to believe that the inflationary burst will fade, but some concerning signs suggest it may last.

Is inflation bad? It depends on the circumstances. Fast price increases spell trouble, but moderate price gains can lead to higher wages and job growth.

How does inflation affect the poor? Inflation can be especially hard to shoulder for poor households because they spend a bigger chunk of their budgets on necessities like food, housing and gas.

Can inflation affect the stock market? Rapid inflation typically spells trouble for stocks. Financial assets in general have historically fared badly during inflation booms, while tangible assets like houses have held their value better.

The U.S. government stands behind all Treasurys. In crises, investors from all over the planet buy them for that reason.

Why have my bond mutual funds and E.T.F.s lost money, then?

These publicly traded funds are required to reflect the market value of the securities they hold, and the value of many bonds has been dropping.

Rising yields will eventually benefit bond fund investors, though, said Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research. That’s because the total return you receive from a bond fund is a combination of the price change and income from the bonds, and the income is rising.

What about corporate bonds? Are they risky right now?

Investment-grade corporate bonds aren’t as safe as Treasurys, but most of them should be fine, as long as you hold on to them until they mature.

High-yield or junk bonds are riskier, by definition. They may not be suitable for conservative investors.

How about consumer and business interest rates? Are they going up?

Yes, mortgage rates have shot up more rapidly since the start of the year than in any 13-week period since May 1994, Ms. House of Wells Fargo said. The average rate for a 30-year fixed-rate mortgage reached 4.67 percent on March 31, according to Freddie Mac — an increase of 1.56 percentage points since the start of the year.

Other rates that affect consumers and businesses, from credit cards to car leases and purchases and private student loans, to loans for the purchase of equipment or shares of stock, are also increasing.

This is all gloomy so far. Is there any good news here?

Yes. Strategists have argued for years that because bond yields have been so low, “there is no alternative” to stocks — a claim that has its own acronym, TINA.

Well, there are plenty of alternatives in the bond market now, Ms. Jones said. If you buy new bonds, you will be getting much better interest rates than you would have received a year ago. “This is beginning to be a good time for income investors,” she said. “You can start picking up decent yields in investment grade corporate bonds now.”

Mr. Davis of Vanguard put it this way: “This is a transition, and transitions are painful,” he said. “But near-zero interest rates weren’t sustainable. It will be a good thing if rates are higher. That should improve the outlook for stocks and bonds over the long term, once we get through it.”

Getting through the price declines is the trick, though.

Unless you’re confident about your ability to time the market — and I’m not — it may be best just to stick with a long-term plan. But that entails accepting some losses when stocks or bonds decline in price.

That may not be pleasant. Yet enduring pain is part of investing, if you do it long enough. I’m trying to focus on the gains I’ve had over the last decade, not the declines over the last several months.