Ask an Advisor: I lost $137,000 in the bond market. Should I liquidate or hold the course? Investments are in an IRA so I cannot write off the losses.

Ask an Advisor: I lost $137,000 in the bond market. Should I liquidate or hold the course? Investments are in an IRA so I cannot write off the losses. – Anonymous

The first question to ask yourself is – “Why did I decide that bonds belong in my portfolio?”

Has that reason changed?

If an asset is part of your financial plan, recent performance shouldn’t affect your decisions. There will be times when part of your portfolio is experiencing poor performance. This is normal and doesn’t necessarily mean it was a wrong decision to own those assets. An efficient portfolio is designed to work as a system, and performance should be evaluated as a whole over multiple years.  

I don’t recommend abandoning a long-term investment strategy because of recent losses. That’s like closing the barn door after all the cows have run away! While bonds aren’t as volatile as stocks, they can have moderate swings in a short period as we saw in 2022.

To help you better understand the fixed-income asset class, I’ll cover some fundamentals:

First, you can expect riskier (more volatile) investments to generate higher long-term returns than lower-risk investments. This is why stocks have higher expected returns than bonds, and riskier bonds have higher expected returns than less risky ones.

Two Types of Risks When Investing in Bonds

Next, let’s talk about the two main types of bond risk: duration and credit.

Duration Risk: Interest rates and bond values move in opposite directions so when interest rates go up, bonds fall in value and vice versa. This asset class got slammed in 2022 because the Federal Reserve raised interest rates seven times. There’s a silver lining to interest rate increases, though – bonds are now paying higher income (yield). In the case of bond funds, the new bonds that enter the fund to replace older ones will generate higher yields. This higher income will, over time, offset the value lost from the interest rate increases.

The number of years it takes for the effects of interest rate increases (value decrease + yield increase) to neutralize each other is approximately equal to the fund’s duration. Duration is a gauge of interest rate sensitivity and is a common measure to use when comparing bonds. High-duration funds hold longer-term bonds and will be more sensitive to rate changes compared to short-duration funds.

Credit Risk: Credit risk is the possibility that you may not receive the interest or principal you’re promised. Treasuries (government bonds) are considered to be zero credit risk because the government can simply tax its way out of budget challenges. Corporations don’t have that same ability – they can go bankrupt and default on their debt. The less stable a company is, the higher the risk of default, and the lower its bond values. Remember – lower value means higher yields! Low quality corporates are also called “junk bonds.”

Revisit Your Goals

Now, back to your goals.

It’s important to understand that fixed-income assets can provide varying degrees of stability, diversification, and/or income depending on the type that are selected.

1. Stability: Short-term bonds are more stable and less sensitive to interest rates than long-term bonds.

2. Diversification: Treasuries are a better diversifier for a stock-heavy portfolio than corporate bonds because treasuries are free of credit risk. There is usually a flight to safety during economic downturns, and this often causes treasury prices to rise while stocks are falling. This effect stabilizes the overall portfolio and reduces volatility. Corporate bond values get dragged down during recessions (due to credit risk) and fail to provide diversification when it is needed the most! Long-term treasuries are considered to be better diversifiers than short-term treasuries.

3. Income: Short-term bonds are less risky (duration) than long-term bonds so they pay lower yields. Corporate bonds are riskier (credit) than treasuries and have higher yields. High-yield corporates (junk bonds) are higher income and are risker than investment-grade corporates.

As you can see, there is no free lunch. If you want more stability, you’re giving up some diversification and income. If you want more income, you’re giving up some stability and diversification. Think about your asset mix (stocks/bonds/alternatives/cash) as a whole and the role(s) you want bonds to play. Choose the appropriate type for your objective.

A suitable portfolio balances risk with return and aligns with your goals, timeline, and risk tolerance. Reach out to an independent, fee-only advisor If you need help creating a financial plan and designing an investment portfolio that is right for you.

Allen Mueller, CFA, MBA, is a financial advisor based in Dallas, Texas, who serves clients nationwide. As the founder of 7 Saturdays Financial, Allen helps busy professionals engineer their roadmap to financial independence. 

Get to know Allen by visiting his profile page on Wealthtender or visiting his website at 7saturdaysfinancial.com.

Please note that Wealthtender earns a nominal monthly fee from Allen in exchange for providing access to the benefits described here, subject to these terms. This compensation creates a natural conflict of interest when we favor promotion of Allen and other financial advisors in the Wealthtender community over advisors not featured on our platform. Wealthtender is not a client of these advisors or firms.

This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.

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