Bonds in Portfolios
Many investors add bonds to their investment portfolios as a way to invest “safely”, to earn some type of return without the volatility of equity investments. To their surprise in 2022, they quickly found that bond prices can and do fluctuate, often with more volatility than they imagined.
What is a Bond? It is an I.O.U
A bond is simply a an I.O.U., a piece of paper that tells you, the lender, the terms of the loan you’ve made to the borrower. For example, when you buy a 10-year Treasury bond at 4.0% interest, you’ve loaned the US government $1,000 for a period of 10 years. At the end of the 10 years, you’ll be repaid your principal ($1,000) and every year during the term of the loan, you’ll receive $40, or 4% of the principal value, in interest payments.
Bonds Prices Can, and Do, Change - But Why?
When you lend money you must be compensated for two general risks: the risk the borrower will default and the risk that inflation will make the repaid funds worth less than those originally loaned. The term length of the loan increases the uncertainty of those two risks.
Credit Risk
Credit Risk is the risk that the borrower won’t repay the loan per the terms of the original contract, or even at all. Lenders take in to account the creditworthiness of the borrower and adjust the rate at which their willing to lend accordingly. Suppose two borrowers are available for a loan, one offers the power to tax the entire citizenry to raise money to repay the loan and the other simply offers their word that they’ll repay. Obviously you would charge the borrower who simply says, “Trust me, I’ll repay it,” a higher rate of interest.
Inflation Risk
Inflation Risk arises from the fact that the dollars loaned and the dollars repaid won’t buy the same amount of goods. For example, if one can of Coke costs $1.00 today and inflation is 3% per year, then one year from now one can of Coke will cost $1.03. If you loaned out $1.00 today but only charged 2% interest, you would receive $1.02 in repayment in one year. That $1.02 would no longer buy you a can of Coke—you’d be short a penny and would only be able to buy 99% of one can of Coke.
Time Risk
Time Risk arises from the fact that the longer the term of the loan, the more uncertainty there is in the credit risk associated with the borrower and the inflation risk in the economy. The longer the loan remains outstanding, the less likely we’ll be accurate in our predictions of events that could impact the ability of the borrower to repay and/or our predictions of what the future rates of inflation will average over the life of the loan.
An Example (For Physicist)i
Suppose you lend $1,000 to the US Government for 5 years. You assume there is no credit risk with the US government and also assume inflation will average 3% over the next 5 years. You thus buy a US Treasury bond, or lend to the US government, $1,000 for 5 years at 3% interest. Each year, you’ll receive $30 of interest, and in year 5 you’ll also receive back your original $1,000.
Later, we calculate inflation averaged the 3% you predicted. At the beginning of the 5 year period a new TV costs $1,000. Five years later, that same TV costs $1,159. You’ve received your original $1,000 back plus $150 in interest so now have $1,150 and can still buy the TV.ii
1982 vs. 2022: Two Extremes
In 1982 the market yield on the 10 year Treasury bond was 13.98%iii while inflation expectations for the next 10 years registered at 6.20%.iv Actual inflation over the next 10 years dropped significantly however, and through 1991 only averaged 4.12%.v An investor buying the 10 year Treasury bond collected 14% while inflation was only 4%--a 10% difference! That’s one reason people fondly remember the bonds they purchased in the 1980s.
Fast forward to 2022. The yield on the 10 year Treasury bond at the beginning of 2022 was 1.52 %. Inflation expectations, as measured by the University of Michigan Consumer Survey was 4.8%vi and inflation reached 9.00% in June of 2022, just 6 months later!vii Earn 1.5% and lose 9% to inflation? It’s no wonder the price of the 10 year Treasury bond dropped 10% by October of 2022viii and no wonder investors are starting to rethink their investments in bonds!
Individual Bonds vs. Bond Funds
If you own an individual bond the value, or the price at which you can sell that bond to another investor, changes from day to day. As we experienced in 2022, that price change can be negative and it can be dramatic. However, if you continue to hold the bond to maturity you will continue to receive interest payments during the term of the bond and, at maturity, you’ll receive back your initial investment. Any paper losses will evaporate as the maturity date approaches.
Bond mutual funds (and ETFs) do not have a maturity date. The losses in bond funds reflect the lower prices of the bonds and because the funds do not have a maturity date, an investor can’t “wait out the loss” to maturity. Instead, it’s incumbent upon the fund manager to take advantage of their ability to navigate the market to try to make those losses up.
Tax Loss Harvesting Bonds and Bond Funds
If you own bonds or bond funds in a non-retirement account, and those investments are worth less than what you paid, you can make the best of a bad situation, just as you can with equities, by selling those investments to recognize the loss for tax purposes. Those losses can then be used to offset recognized gains in other areas of your portfolio.ix
WealthBridge Capital Management is ready to help you evaluate your income plan, to include Roth contribution and conversion analyses, Social Security benefit timing, and retirement plan distributions. If you don’t have a retirement income plan, or your need to update or review your current plan, please reach out to us at 614-591-4515 or email us at info@wealthbridgecm.com to schedule an appointment.
i A nod to physicists who examine problems starting with the simplest solutions as remarked by Leonard Hofstadter, “I have a solution, but it only works with spherical chickens in a vacuum!”, Big Bang Theory, “The Cooper-Hofstadter Polarization”, Season 1, Episode 9.
ii The slight difference arises because in this example the annual interest payments of $30 are not invested.
iii Board of Governors of the Federal Reserve System (US), Market Yield on U.S. Treasury Securities at 10-Year Constant Maturity, Quoted on an Investment Basis [DGS10], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DGS10, June 4, 2025.
iv Federal Reserve Bank of Cleveland, 10-Year Expected Inflation [EXPINF10YR], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/EXPINF10YR, June 4, 2025.
v World Bank, Inflation, consumer prices for the United States [FPCPITOTLZGUSA], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/FPCPITOTLZGUSA, June 4, 2025.
vi "Surveys of Consumers, University of Michigan, University of Michigan: Inflation Expectation© [MICH], retrieved from FRED, Federal Reserve Bank of St. Louis https://fred.stlouisfed.org/series/MICH/June 4, 2025.
vii U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: All Items in U.S. City Average [CPIAUCSL], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CPIAUCSL, June 4, 2025.
viii Performance as shown from LSEG Thompson One, 01 JAN 2022 – 24 OCT 2022.
ix WealthBridge Capital Management does not offer tax advice. Please consult your tax professional for information specific to your situation.