Retirement Answers

Jacob: 00:00

Well, hello there, and welcome back to Retirement Answers. My name is Jacob Duke. I'm a certified financial planner, and I help folks just like you retire on a daily basis. Well, if you paid attention to anything that happened in 2022, you saw that the markets were just not fun all the way across the board. Most of us watch the stock market go down by 19%, which is not fun as an investor, but we somewhat expect that to happen from time to time.

Jacob: 00:25

We know that the stock market is volatile, and if we have any money invested for any amount of time, we've seen that reality take place in our accounts. In fact, history has shown that the stock markets will decline by 20% every three or four years and at least 10% every other year. But I believe that the bigger story in 2022 was not stocks. It was bonds. What happened in bonds was shocking to most of us, but once we talk through the fundamentals of how bonds work, perhaps it'll make a little bit more sense to you.

Jacob: 00:52

And and kind of the whole purpose of having this discussion is I had a recent question come in, and it was basically just this. Are bonds still a viable investment in 2023 for retirees? And the reason that this question even came up is because global bonds last year in 2022, the values declined by 12%. So, yes, you heard that right. Stock markets went down 19% last year, and bond markets went down 12%.

Jacob: 01:16

The most shocking thing about this, though, is that most of us think that bonds operate in inversely of stocks, or they go in opposite direction. So if stocks go up, bonds go down. And so we think that stocks and bonds work inversely of each other. And most of the time, that is correct. If stocks go up, bonds are typically gonna go down or vice versa.

Jacob: 01:35

So bonds kinda play this trick on us and make us think that these two asset classes are non correlated, which is not entirely true. So to understand what happened in 2022, let's run through a quick review of bonds and how they work. Alright. So, when you purchase a bond or a fund that invests in bonds, you are lending your money to that company or government, and they are promising to give you your principal back at maturity, and they're also promising to pay you interest along the way. This is different from a stock because whenever you purchase a stock or a fund that invests in stocks, you're actually buying a piece of a company.

Jacob: 02:10

Therefore, you become a part owner in that company. So you would be a really small part owner, but nonetheless, you are an owner. So fundamentally, you are either what I would call an owner or you're a loaner as an investor. So as an owner or a stock buyer, you have much of a higher upside than a loaner, which is a bond buyer. And as an owner, if the company explodes and grows like crazy, the value of your small piece of ownership is going to go up by that much.

Jacob: 02:38

As a loaner or someone who buys bonds, you're still going to own your bond regardless of how well the company does. So you're simply just gonna receive your, for example, 3% interest and then get your money back in twenty years. And when I say something like that, I'm like, why in the world would I own a bond? But that's a different discussion for a different day. So one important thing I want you to know is that bonds are a zero sum game.

Jacob: 03:01

So what do I mean by that? Well, if you hold your bond until maturity, you're gonna collect the interest along the way that you were promised, assuming the bond doesn't default, and then you will also, get your principal back upon maturity. See, you didn't lose any money. So why did bonds decline in value by 12% in 2022? Well, just to make sure we're on the same page here, what is actually being asked is why did the value of my bonds go down?

Jacob: 03:28

See, there are two primary determinants in bond valuations, interest rates and then time to maturity. So in my opinion, the longer the maturity, the more risky the bond fund is, especially if you think, interest rates are gonna go up. Right? So if you buy a bond today with a 3% interest rate and that's for thirty years and then interest rates raise to 5% and but you're locked into a thirty year bond, well, that's pretty risky, right, because you're not getting the highest potential return that you could. So in 2022, we kinda saw this.

Jacob: 03:56

We saw the Fed begin increasing interest rates at a rapid pace. This came after years of declining rates, especially during 2022 especially during 2020 whenever COVID was going on. So let's take a quick look back at bond returns, over the last couple of years. In 2022, we saw the bond market go down about 12 or 13%. In 2021, the bond market was fairly flat.

Jacob: 04:19

In 2020, we saw the bond market increase by 7.7%. And then 2019, it went up 8.71%. So if we look if we're just looking at that, we can see it's kind of a different story on each side. 2022 and 2021 were not good from a bond return standpoint. 2020 and 2019 were great.

Jacob: 04:37

So we see that in 2019, 2020, you know, the bond values increased at a greater than average rate. And in 2022, bonds declined at a larger than average rate. What else happened over this four year period? Well, interest rates went down to all time lows on the front end, so 2019 and 2020, and then they rapidly increased in 2021 and 2022. So if I were able to show you two lines on a graph where one of them was interest rates and the other was bond values, they would be going in opposite directions.

Jacob: 05:06

So as interest rates were declining, bond values would be increasing. And then whenever interest rates would be increasing, bond values would be declining. But, Jacob, that doesn't make any sense. Why would bond values decline when interest rates are getting higher? Well, here's an example.

Jacob: 05:21

Let's say that you bought a bond in 2020, and then it was paying you 2% interest. Then in 2022, I could buy this exact same bond from the same company, let's say, and it was paying me a 5% interest rate. Why in the world would I buy your 2% bond from you whenever I can get one for 5%? It wouldn't make sense to do that unless you discounted your bond price so much that it made sense for me to buy a 2% bond instead of a 5% bond at full price. So the opposite will be true whenever interest rates decline.

Jacob: 05:53

Bond purchased a year ago paying 5% would be worth more than new bonds only paying 2% today. So I would be willing to pay more for a 5% bond because I can't get a better rate than that today. So that's probably one of the biggest things to know is that the value of your bonds is gonna be changing as interest rates go up and they go down. And so the reality is is that's what we saw over the last four years or so. We saw interest rates going down to all time lows.

Jacob: 06:22

Therefore, the value of bonds that were out there in the market already were increasing in value. Right? They were going up because you couldn't find a bond at the interest rate that you could five years ago or two years ago because interest rates were so low. And then whenever we had people buying bonds at that low interest rate and then, interest rates rise and now we can find new bonds at a higher interest rate, no one wants to buy the bonds that were just purchased a year or two ago because now I can get a better rate. And so that's why you see the kind of over the last few years, this really, really rapid up and down volatility in bond values because of interest rates kind of being so weird going up and down drastically.

Jacob: 06:59

So let's kinda just round this all out by saying that, yes, bonds are absolutely viable as an investment option, in 2023 still. The reality is is they will stabilize. It's just a matter of when. So it's kind of indicative upon, you know, when will the Fed stop raising rates, and does that allow that bond markets to kind of slow down in terms of increasing interest rates, which will also allow the value of those bonds to begin to flatten out a little bit and become more accurate. So here's the takeaway I want you to know is if you were investing in bonds over the last couple of years and you're like, man, my bond funds went down by twelve, fifteen, 10%, something like that.

Jacob: 07:37

Should I sell them now and and wait for the bonds to go back up in value or not? Well, here's what you should do. You should hold on to them because over time, it just takes a certain amount of time for those bond values to work themselves out. Remember back when I said at the beginning of the the show that bonds are a zero sum game, meaning if you hold them to maturity, you will get your principal back, and you will get your interest rate that you were guaranteed. So that's what I would say is is over the next one, two, three years, you're gonna see the value of your bond funds slowly begin increasing and going back up.

Jacob: 08:11

And it was just kind of a way of finding equilibrium. So it's not something that I would say be alarmed about. The the key to investing in bonds is simply hold on. You can't beat the bond market like it will work itself out. You will get your money back assuming that you hold on to things and don't panic sell.

Jacob: 08:29

So I hope that's kind of a quick little, answer to the question of should I still be investing in bonds? Are they still a viable investment option? Yes. They are. In the right situations, obviously, you know, create a retirement income plan and the whole thing.

Jacob: 08:42

They're they're absolutely valuable for that. Just know that right now in the present kind of situation, they just don't look good. But as I've explained, you know, they will work themselves out. We will see the values kind of return to where they were, and things will make more sense over the next year or two as things stabilize. But if nothing else, just know that that's how bonds work.

Jacob: 09:00

Interest rates, time horizons, time to maturity, you know, those types of things are some of the biggest determinants. So remember this. As interest rates increase, typically, bond values are gonna decrease. As interest rates decline, the bond values are going to increase. So they kinda work in opposite directions of each other, and that's the biggest thing is that most people have confusion around is they don't understand how bonds work in terms of pricing.

Jacob: 09:24

So, hopefully, this has been helpful. And if you did find it helpful, I encourage you to go online, give us a review, give us a rating, and that will be super helpful as as other people are searching for good retirement information. And once again, my name is Jacob Duke. I'm a certified financial planner, and this has been another episode of Retirement Answers. I look forward to speaking with you again next week.