Stocks and bonds both get clobbered this time. Here's what's behind the double whammy
Deborah McDaniel is a retiree who has her life savings in a mix of both stocks and bonds, which she thought was a responsible, safe approach.
But her portfolio got "hammered," she says. "Down about...25% over the last 18 months."
McDaniel's not alone. So far this year, the S&P 500 stock index is down 23%. When stocks fall, bonds usually hold their value or even see it rise. But not this time. Bond market index funds are down about 15% over the past year.
All that's brought the value of McDaniel's retirement account down to around $400,000 from upwards of $500,000.
"Maybe I need to find a job again," McDaniels says she finds herself thinking. Which at 69 years old is, "not something I relish doing."
The culprit behind stocks and bonds falling at the same time: inflation. It turns out, inflation is not just just hurting you through higher prices at the grocery store and your electric bills, if you own bonds it's tanking their value too.
Owning both stocks and bonds is a basic concept of investing. Stocks tend to make you the most money over long periods of time. But they're risky and can be volatile. Bonds are more like the slow steady turtle paying you a fixed predictable rate of return.
Inflation is tanking your bond fund
In normal times, when worries about a recession pushes down stocks, the Federal Reserve would cut interest rates to boost the economy. That also has the effect of pushing up bond prices. But that's not happening now.
"This is one of those rare years when both bonds and stocks work against the investor," says David Kotok, chief investment officer at Cumberland Advisors.
"This time, the Federal Reserve has a different problem," Kotok says. The worst inflation in 40 years is threatening to become embedded in the fabric of the economy. So instead of cutting interest rates, the Fed is trying to fight inflation by raising interest rates a lot to slow the economy.
That's basically what's pushing down bond prices.
"The reason that bonds drop in value is that interest rates rise," says Rick Miller, an economist who runs the advisory firm Sensible Financial near Boston.
Turtles all the way down
When governments or companies want to borrow money, they issue bonds. And they pay interest to investors that buy the bonds.
Bond pricing is not the most intuitive thing, so to understand how this works, picture the bonds in your bond fund as those slow steady turtles.
"Your turtles have numbers on their backs," says Miller.
Let's say they have two's on their backs because they're paying you 2% a year on your investment. They keep doing that, every year, guaranteed, that's how bonds work. (The return is guaranteed unless the company or government that issues the bonds can't pay and defaults.)
But when interest rates rise, new bonds get issued and those pay a higher interest rate, so people can buy bonds that pay back more, say 5%. They're like faster, better turtles.
So if you decide to sell your bonds paying 2%, why would investors want them?
"You could say, well, my turtle is still a nice turtle. It's a really cute turtle. But if you want to sell it, you're going to have to give them a discount," he says.
And that is exactly what happens in the bond market, where the value of the bonds you already have drops.
Your bonds still pay you the same money
However, if you choose not to sell them, your bonds will continue to pay you the same return on your initial investment.
"Your turtle's not dying, your turtle's not even sick," says Miller. It's still paying you 2% on whatever you invested, the same as before. It's just investors have better options so it's not worth as much if you want to sell it now.
Technically, on paper what happens is the price and value of the bonds drops, and the interest rate they return, the yield, rises so that the yield reaches equilibrium with interest rates on new bonds being issued in the market. But the effect of all that is that you still get that 2% return same as before on the amount of money you invested.
So Miller says don't panic and sell all your bonds, just stick with your financial plan. Because someone like retiree Deborah McDaniel-- if she was making $10,000 a year in interest income off the bonds in her retirement portfolio, "it should still be generating $10,000 a year, that bond fund." Even if the price on the bonds falls, that doesn't change.
So in that sense with bonds, things are not as bad as they might look. And it's actually even better than that. Miller says as time goes on, some of those bonds in your fund paying 2% are going to mature and be replaced with newer bonds paying a higher interest rate if rates stay elevated. So down the road you'll be making more money.
All that is reassuring to McDaniel.
"It's good to know that my entire portfolio hasn't tanked," she says.
The problem for retirees of course is that many do have to sell some bonds from their retirement account to pay for expenses. So the lower price right now does hurt them them when they sell.
On the other hand, if you're still working and stashing money away, the bonds you buy now will be paying you more money for years to come.
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