Is it reasonable or even wise to shift some of your bond allocation to money-market funds paying over 5%? Bonds have had a terrible year in 2022 and are barely treading water in 2023. With uncertainty about further rate hikes, doesn’t it make sense to do this?”
—Amita Desai, Demarest, N.J.
It’s very understandable to be disappointed in bonds’ performance of late. The broad bond market had its worst year ever in 2022, as reflected by the AGG—the iShares Core U.S. Aggregate Bond ETF—which fell 13%. So far this year, that exchange-traded fund is up a paltry 1.45%, less than half the rate of inflation.
And further risks lie ahead: If the Federal Reserve continues to raise interest rates, the value of existing bonds will likely fall. That’s because higher rates make newer bonds more attractive to investors, driving down the prices of older ones. “I completely understand the frustration,” says San Francisco-based financial advisor Adrianne Yamaki.
While bonds have been sucking wind, there are lots of attractive alternatives out there. The Vanguard Federal Money Market Fund (VMFXX), for example, was recently yielding 5.2%. You can also get close to that yield through bank savings accounts, without the market risk that money-market mutual funds are subject to. The best one-year bank certificates of deposit are yielding 5.6%. Individual Treasury bonds are also attractive right now; a one-year T-bill will yield you 5.4% if you hold it to maturity.
In short, a whole range of savings and investment vehicles are paying higher levels of interest than they have in many years. You can thank the Fed, which has aggressively raised the benchmark federal-funds rate over the past 18 months to fight inflation.
Bonds vs. money-market funds
So should you really sell bonds and use the proceeds to buy these products?
It depends on what you want to achieve, say financial planners. If you plan to use the money in the next year or two, then jumping into a money-market fund or other high-yielding investment could pay off. “For shorter periods, money markets can absolutely make a lot of sense,” says Brent Weiss, co-founder of financial advisor firm Facet, in Baltimore.
On the other hand, if the bonds in question are part of your retirement portfolio, you might want to ride out the tough times. Bonds can be an important diversifier; when stocks crash, they can prevent a total washout. In 2018, was down about 6%, the iShares Core U.S. Aggregate Bond ETF was flat. In 2008, stocks plunged more than 36%, but that same iShares ETF was up 5.2%. Even in their dismal 2022, bonds still beat stocks by nearly 6 percentage points.
Bonds have also performed better historically than the “cash” category, which includes money-market funds. From 1928 through 2022, bonds returned 4.6% annually, compared with 3.3% for cash, according to New York University finance professor Aswath Damodaran. (It’s worth noting that stocks creamed them both, with a 9.6% annual return).
Also bear in mind that if you decide to temporarily trim your bondholdings, you might find they’re more expensive when you want to buy back in. “That’s where we start to miss out on the returns that the markets tend to give us over longer periods of time,” says Weiss.
Check your stock-bond split
One more thing to consider: If bonds’ recent performance is dragging your retirement portfolio down, it may be because you’ve overweighted them in your portfolio’s stock-bond mix.
Investors who are far from retirement should own more stocks and fewer bonds because over time stocks are more likely to deliver the gains they’ll need. Investors who are closer to retirement should own more bonds, in part because they can provide a stream of retirement income.
One formula for determining the right balance of stocks and bonds is known as “120% minus your age.” If you are 40 years old, for example, you should hold 80% of your portfolio in stocks and 20% in bonds.
Choosing the right short-term vehicle
If you are likely to need your money within the next six months or a year, you should absolutely look at money-market funds or similar alternatives. But remember that for each, there’s more to consider than just yields.
Money-market funds are considered a low-risk investment, and one that’s easy to sell if you need cash. Note that the highest-yielding variety are taxable, and they’re not FDIC-insured. Treasury bonds offer higher yields, but can gain or lose value based on market shifts. Treasurys can also be attractive if you live in a high-tax state like New Jersey, points out Yamaki, since they are exempt from state and local income taxes.
High-yield bank savings accounts offer easy access to your cash and are FDIC insured up to $250,000. But their yields can fluctuate as the Fed adjusts interest rates. You can avoid that problem by buying a CD, but remember there are penalties for early withdrawal.
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Meet the contributor
Steve Garmhausen
Steve Garmhausen is a contributor to Buy Side from WSJ.
