When the Fed started its tightening cycle back on March 17, 2022 to help quell inflation, the target rates for Fed Funds were 0.25%-0.50% and they now sit at 4.50%-4.75%. Today, you can easily find 1-year bank CDs paying just about 5.0%! As expected, the increase of rates at the short end of the curve caused the yield curve to invert, i.e., higher rates at the short end compared to the longer end, but also increased up and down volatility in all interest rates and bond values.
As seen from the chart below, core bond (AGG, the blue line) returns have been on a roller coaster ride similar to stocks (IVV, the green line); stocks showing lots of zigging and zagging, but bonds did too, though not as much! The only respite from volatility has been from shorter duration bond exposures, like the iShares 0-5 Year Investment Grade Corp ETF (SLQD, the gold line) that shows a “smoothish” path and only a modest annualized loss over this time horizon of -1.4%.
The idea that bonds are “less risky” than stocks is well documented, but depending upon their characteristics, they can still be “risky” investments. As we at D&A have communicated consistently, we believe that diversification is key to aid in the success of long term investing; and that diversification includes management of the bond sector allocations. We believe that a well-managed bond allocation needs exposures to all parts of the yield curve and, during a Fed tightening cycle, a shorter overall bond duration exposure.
The modified duration of “core” bonds (AGG) recently has been about 6.3 years; modified duration being a proxy for risk over a time horizon. No one knows the path that interest rates will take, but the Fed has communicated a clear focus to increase rates until inflation appears quelled. Therefore, a shorter bond modified duration than the core bond proxy is warranted. Most all D&A client accounts have an exposure to “core” bonds, but also to very short bonds (NEAR and BKLN) and short bonds (SLQD) to account for an overall bond modified duration in the range of 4.0 years; shorter than the core bond proxy of 6.3 years.