How Not to Invest in Bonds

By J.R. Robinson, Owner/Founder 

The impetus for this article was a recent MarketWatch article titled “Investors Are Piling Into Bond Funds at a Rapid Rate. That’s a Problem.”

The article caught my attention because investors are once again pouring money into bond mutual funds and ETFs. Some are undoubtedly doing so because bond yields are much higher than they were a few years ago. That sounds logical. If interest rates are higher, bonds pay more.  What could go wrong with that strategy?

The answer is, “Plenty.”

For decades, 401(k) participants have been taught a simple rule of portfolio construction: stocks are the risky part of a portfolio and bonds are the safe part. As investors get older, they should gradually reduce their stock exposure and increase their allocation to bonds.

Target-retirement-date funds institutionalized this thinking. As the retirement date approaches, these funds typically shift money from stocks funds into bond funds.

The problem is that bond mutual funds are not necessarily as conservative investments as they are perceived. In fact, in a secular rising interest-rate environment, they can be downright volatile.

That is why we emphatically eschew the use of bond funds for the safe portion of our clients' portfolios. We typically use individual U.S. Treasuries, CDs and occasionally government agency securities instead of bond mutual funds or ETFs.

Forty Years of Falling Interest Rates Made Bond Funds Look Safe

It is important to understand how we the populist “bond funds-are-conservative” narrative developed.

Interest rates peaked in the early 1980s on the heels of the 1970s Stagflation period, and slowly but steadily trended downward for roughly four decades. The 10-year Treasury yield, which reached nearly 16% in 1981, eventually fell below 1% in 2020. 

That extraordinary decline created a wonderful environment for bond investors because bond prices (i.e., valuations) move inversely to interest rates.

When interest rates fall, existing bonds that were issued with higher yields become more valuable.

As a result, generations of investors, financial advisors, and portfolio managers became accustomed to bond funds not only generating income but frequently appreciating in value as well.

That helped create the perception that bond funds were inherently conservative.  

That is not to say that interest rates did not rise during that period.  In fact, there were many years in which interest rates nominally rose.  However, over that 40-year period there were just four years in which the total return (interest paid + appreciation/depreciation) on the 10-year treasury index was negative. 

That is why the period from 1981 to 2020 is considered the mother of all secular interest rate trends.

But what happens if the secular decline turns into a secular increase in interest rates?

As we will see, the total return arithmetic works in reverse.

What Happens to Bond Values If Rates Rise Just One Percentage Point?

Suppose interest rates rise by one percentage point. For instance, a 4% Treasury yield becomes 5%.

The approximate decline in the market value of Treasury securities of different maturities might look something like this:

These are estimates. The actual change depends upon the bond's coupon, maturity and other factors. 

Note:  The lower a bond’s coupon rate, the greater the volatility.  For instance, a zero coupon treasury will exhibit greater price volatility than an interest-bearing treasury with the same maturity date and yield to maturity. 

While the 30-year U.S. Treasury has virtually no conventional credit/default risk, as you can see from the estimates above but it can lose15% or more of its market value from just a relatively modest one-percentage-point increase in interest rates.

That is not my definition of a safe investment.  In my experience, most consumers don’t believe a 15% decline in value is consistent with a conservative investment either.

Bond Funds Make the Problem Worse

There is also an enormously important distinction between owning an individual Treasury and owning a Treasury bond mutual fund or ETF.

Suppose I purchase a $100,000 Treasury note and hold it until maturity. I know the contractual interest payments. I know the maturity date. Most importantly, I know that the U.S. Treasury is obligated to return the $100,000 face value at maturity.

The market value may fluctuate along the way. If rates rise substantially, my statement might temporarily show that my Treasury is worth only $95,000.

But if I do not need to sell it, I don't particularly care - At maturity, I get my $100,000 back.

A traditional bond fund is different. It never matures.

The fund continually replaces maturing bonds with new ones in an effort to maintain its stated maturity and duration characteristics. There is no date on the calendar when the investor can say, “My bond fund matures today, and I get my principal back.”

That makes bond funds fundamentally different from individual bonds held to maturity.

It is also why I believe bond funds can be much riskier than individual Treasuries or CDs when the purpose of the investment is to provide stability.

2022 Should Have Been a Wake-Up Call

Anyone who still believes bond funds are inherently safe should revisit 2022.

As the Federal Reserve aggressively raised interest rates, bond prices plunged. The Bloomberg U.S. Aggregate Bond Index lost approximately 13% for the year.

Long-term bond funds did considerably worse.

At the same time, stocks were falling.

That created a nightmare scenario for investors who had been told that bonds would protect them when stocks declined.

Target-date retirement funds provided an especially important lesson.

Vanguard's Target Retirement 2025 Fund lost approximately 15.5% in 2022. This was a fund designed for people who were only about three years away from retirement.  In 2022, it was already close to its final target allocation of 50% stocks funds and 50% bond funds.

Let that -15.5% figure sink in a bit.

In my experience, most workers approaching retirement have been taught by their 401(k) plan provider’s educational literature to believe that a target-date fund with a large bond allocation is conservative.  In my experience, I have also observed that double digit declines in portfolio value are inconsistent with consumer expectations from investments labeled conservative.

The assumption that increasing the bond allocation automatically makes a portfolio safer deserves far more scrutiny than it receives in the public discourse – and in the 401(k) plan participant literature.

So, About That Money Pouring Into Bond Funds Today

If we apply the principles discussed above, the fact that money is “pouring into bond funds” just as rates are beginning to seems more like leaning into a right hook than a flight to safety. 

To drive this point home with tangible data, the year-to-date total return through 8/28/2026 of the Vanguard Intermediate Term Treasury Index Fund is -.68%.  The Vanguard Long Term Treasury Index Fund stands at -2.27%.  That is the total return, which includes the interest paid on the bond. 

What about Treasury Inflation Protected Securities (TIPS) Funds some may ask?  Many consumers perceive these bond funds to be safe because the principal on TIPS is adjusted each year to match inflation. 

For reference, the YTD return on the Vanguard Inflation Protected Securities Fund is a paltry .47% through 8/28/2026.  In 2022, the fund lost 11.85% of its value!  What many people do not understand about TIPS is that the inflation protection does not eliminate price volatility.  Because TIPS are offered with coupon rates much lower than ordinary treasuries, their price volatility may be viewed as akin to zero coupon bonds.

Financial Planning Hawaii Believes the  “Safe” Portion of Your Portfolio Should be Safe.

This discussion gets to the heart of how we construct portfolios for our clients.

Stocks are supposed to be volatile. We own them because, over long periods, we expect to be compensated for accepting that volatility.  Most individuals investors understand and accept that.

The so-called “conservative” portion of a portfolio has a different job.

At our shop, we want the safe portion of client portfolios to be as close to risk-free as reasonably possible.

If the stock market declines 30%, the conservative portion of client portfolios should not be down 10% or 15% at the same time.

That is why we do not use bond funds or bond ETFs.

For the safe portion of client portfolios, we primarily use individual U.S. Treasury securities and CDs. We purchase them with the expectation that they will be held to maturity. If you buy a 24-month CD today that is paying 4.2% and hold it until it matures, your return on that investment is known from the day it is purchased no matter how much interest rates may rise or fall (assuming we purchase with the FDIC coverage limits).  The same holds true for individual treasuries.

There is still market-value fluctuation if either security is sold before maturity, but most people are willing to hold for few years to avoid a nominal market decline. Most consumers are not able to wait 10 years or longer to maturity.

We Don't Reach for Yield

We typically do not extend our Treasury and CD ladders beyond five to seven years.

The reason is simple.

We can often capture roughly 75%-80% of the yield available farther out on the yield curve without accepting nearly as much interest-rate risk.

Why own a 20- or 30-year bond to squeeze out a little more yield when a relatively small increase in rates can cause its market value to plunge?

We would rather sacrifice some yield in exchange for dramatically less volatility.

Our ladders are also dynamic.

When interest rates are rising and investors are being adequately compensated for extending maturities, we gradually extend the ladder. When rates are low or the yield curve offers little compensation for taking additional duration risk, we keep maturities short.

At this time, we generally are not extending beyond two years.

If rates move higher, maturing securities give us the opportunity to reinvest at those higher rates. If the yield curve eventually offers attractive compensation for extending maturities, we can extend the ladder then.

We see no reason to predict interest rates when we can simply respond to them.

Conclusion:  Bonds and Bond Funds Are Not the Same Thing

This distinction has become lost after decades of declining interest rates.

An individual Treasury held to maturity and a Treasury bond fund may own essentially the same securities, but they do not provide the investor with the same experience.

One has a maturity date and a defined principal payment.  The other does not.

For investors seeking growth, volatility comes with the territory. That is why stocks belong in long-term portfolios.

But the safe portion of most retail consumer portfolios has a different purpose . It is there to provide liquidity, stability and certainty when the risky portion of the portfolio is behaving badly.

In my view, an investment that can lose 10%, 15% or 20% because interest rates moved in the wrong direction does not belong in that category.

Forty years of generally declining interest rates taught investors that bond funds were conservative.

2022 provided a painful reminder that they aren't always.

If we are going to call part of a portfolio “safe,” we believe it should be as close to risk-free as possible.

Supporting Articles:

How to Build a CD or Treasury Ladder (Charles Schwab)

Don’t Let Them Fool You – Here’s Why Bond Funds Are Not Bonds (Forbes)

Laddering with Individual Bonds (Wade Pfau, Phd, Retirement Researcher)

Why I Always Say “Friends Should Not Let Friends Buy ...

I was Right about Interest Rates

Why friends don't let friends buy bond funds