Headlines have not been kind to bonds. One recent headline read "Global Bonds Suffer Worst Monthly Meltdown as $1.7 Trillion Lost." And the Fed will likely continue to increase rates in 2017.
Rising rates are bad for bonds, so many people have asked me if they should bail out of them. My answer: absolutely not!
1. Why bonds decline when interest rates rise
Before explaining why you shouldn't ditch your bonds, let's first review the relationship between bonds and interest rates. When you buy a bond or a bond mutual fund, you are lending money to either a government (such as the federal government or a municipality) or a company. They will pay you an interest rate and, if no default looms, they will pay your principal back. So if you bought a bond or bond fund yesterday and interest rates went up today, you lent this money at a rate lower than investors want today. Thus they would pay you a bit less to buy the bond or bond fund from you, causing the price of your bond or fund to fall. It's called interest-rate risk.
And the reverse is also true that, if rates declined, your bond or bond fund now pays an above-market rate and thus is worth a bit more.
2. The bond meltdown in perspective
Sure, $1.7 trillion is a lot of money, but let's put it in context. The largest bond fund in existence, the Vanguard Total Bond Index fund (VBTLX), fell 2.63 percent in November, according to the Chicago-based research company Morningstar. That's just a tad more than the 2.58 percent decline of the stock market on one day this year — Jan. 13 — as measured by a broad market U.S. stock index fund. And that's peanuts compared with the more than 20 percent decline in one day of the S&P 500 stock index on Black Monday 1987 or even a 9.1 percent decline on Oct. 15, 2008.
With a little more context looking at 2016 through Dec. 21, bonds have been boring; the Vanguard Total Bond Index fund returned 1.9 percent.
3. The outlook
Will interest rates continue to rise in 2017? "Yes" and "maybe" are my answers. As it did in December, the Fed will likely again push up the short-term overnight rate at which banks lend money to each other, but that doesn't mean bond prices will decline. Most bonds and bond funds (especially intermediate and long-term) are controlled by the market, not the Fed.
Do you think economists can predict intermediate and long-term rates? According to a New York Times article last year titled "We Keep Flunking Forecasts on Interest Rates," they can't. Look back only to early 2014. After a small bond market decline in 2013, experts advised lightening up on bonds. Just like today, I advised back then to not make any adjustment to your bond holdings. And 2014 turned out to be a great year for bonds, with the Vanguard Total Bond fund returning 5.89 percent.
4. What if I'm wrong?
I wish I could promise rates won't go up further, but I can't. But if rates rise, perhaps you shouldn't care. That's because your bond fund will start yielding more as it buys newer, higher-yielding bonds. But you have to stay the course and not bail out.
Keep in mind the role bonds, bond funds and other interest-paying investments are supposed to play in your investment portfolio. They are the more stable part. After all, a high-quality bond fund has less risk in a year than stocks have in a day. But stick with high-quality bonds and funds that invest in them. Interest-rate risk is peanuts compared with default risk. If a company defaults on a bond, you get little or nothing back.
Also consider certificates of deposit (CDs) as bond alternatives.
And remember: Headlines are often exaggerated and can lead us to do silly things, such as selling bonds after a small decline to move into stocks now near an all-time high.
Allan Roth is the founder of Wealth Logic, an hourly based financial planning firm in Colorado Springs, Colo. He has taught investing and finance at universities and written for Money magazine, the Wall Street Journal and others. His contributions aren't meant to convey specific investment advice.