What to Do With Bonds When Inflation Won’t Die

Bonds aren’t boring.

Long-term bond funds lost nearly a third of their value over the past three years. And economic data so far this year, including Thursday’s gross domestic product reading, have rekindled fears that inflation may not be tamed.

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Given this unsettled atmosphere, many Wall Street Journal readers have passionate opinions and searching questions about bonds.

My column last weekend about the volatility of long-term bond funds sparked hundreds of questions and comments. Sorting them into five buckets, I’ll try to answer as helpfully as I can.

Are bonds a sucker’s bet?

Lots of readers, including Terry Blaney and Lawrence Donohue, are worried about the flood of federal spending and the tidal wave of new borrowing by the U.S. Treasury. “Rates will continue to rise until the supply can be absorbed, which may be never,” declared Donohue.  

Since the first quarter of 2020, the total public debt of the U.S. has risen from $23.22 trillion to more than $34.5 trillion—with almost $400 billion expected to be issued next month alone.

Inflation—the mortal enemy of bond investors, who get paid back with dollars that are relentlessly worth less over time—has refused to fade away. The shadow it casts over economic growth helped depress the price of 30-year Treasury bonds this week, driving their yield above 4.8%.

From 1940 through late 1981, inflation averaged about 4.6% annually. Over that period, long-term Treasury bonds lost a cumulative 67.2% of their value after inflation, according to finance researchers Paul Marsh and Mike Staunton of London Business School and Elroy Dimson of Cambridge University. Not until late 1991 did long-term Treasurys recover fully from those losses.

History doesn’t have to repeat itself, or even rhyme. Sometimes it’s blank verse: The lines of the past don’t predict how the future will unfold.

“Could yields go even higher from here? Sure,” says Mary Ellen Stanek, co-chief investment officer at Baird Advisors in Milwaukee, which manages $136 billion.

But that’s a maybe. What we know for certain is that yields have risen substantially in the past three years—and, over time, the best predictor of bonds’ future returns is their current yield. With even short-term bonds offering income above 5%, “you’ve already got that yield buffering portfolios that you didn’t have at the end of 2021,” says Stanek.

Should you buy bonds or bond funds?

Many readers, including Jon Jordan, advocated buying Treasurys yourself—especially T-bills and inflation-protected securities, or TIPS—either through a broker or straight from the government at TreasuryDirect.gov.

You avoid commissions and management fees. If you hold to maturity, you’re certain to get all your principal back—unlike in most bond funds, which don’t mature and can sometimes incur severe interim losses.

One reader says she likes using TreasuryDirect to “set-it-and-forget-it with automatic rollovers,” effortlessly reinvesting the proceeds as Treasurys mature.

TreasuryDirect can’t accommodate individual retirement accounts or 401(k)s, nor can you use it for any securities not issued by the U.S. Treasury.

To sell before maturity, as reader William Guenthner pointed out, you must transfer your holdings from TreasuryDirect to a bank or brokerage firm and sell them there. (You can’t transfer unless you’ve already held for at least 45 days.)

Because TreasuryDirect can be frustrating to use, you could join readers like James Mills and go elsewhere. At leading brokers like Fidelity, Schwab or Vanguard, you can build a bond ladder—a portfolio with maturities spaced from less than one year all the way out to 30 years. (You can use Treasurys, corporate debt or municipal bonds.) 

By staggering when the bonds mature, the ladder provides fairly consistent income without excessive sensitivity to changes in interest rates.

“How bond ‘funds’ are even legal is beyond me,” joked reader Joseph P. Scot. (At least I think he was joking.) Bond funds aren’t all bad, though—if you stick to short-term and intermediate portfolios that aren’t hypersensitive to changes in interest rates.

A bond fund enables you to add or withdraw as much or as little as you wish, without having to wait until maturity—and provides diversification that can be hard to get with individual bonds. Just be sure annual fees are well under 0.6% annually; many exchange-traded bond funds cost 0.1% or less.

TIPS: What’s not to like?

Plenty of readers, including John McHugh, love Treasury inflation-protected securities, or TIPS, whose principal value changes to keep pace with inflation.

Here, you do not want to buy a fund; TIPS funds suffered losses of up to 30% in 2022 when interest rates shot up. (If you held individual TIPS, you wouldn’t have suffered a loss that year unless you had to sell.)

You can build a TIPS ladder, either at TreasuryDirect or a broker. That can be tricky, though, because TIPS aren’t always readily available in the exact amounts and maturities you’ll need. For detailed guidance, see Tipswatch.com, eyebonds.info, tipsladder.com and Bogleheads.org (search: “TIPS ladder”).

Do bonds still diversify stock risk?

“I used to believe bond funds were less risky than stocks,” commented reader T Wilson. “I don’t believe that anymore. I too have lost more money with a bond fund than stocks.”

That’s partly because bonds and stocks have been moving much more in sync with each other than they had for many years. In 2022, as the S&P 500 fell 18.1%, even short-term Treasurys maturing in one to three years fell almost 4%.

For most of the past two decades, bond and stock prices had tended to move in opposite directions—making bonds a powerful hedge against the risk of stocks. In 2008, as the S&P 500 lost 37%, intermediate-term U.S. Treasurys gained roughly 13%.

But the 10-year Treasury began 2022 yielding only about 1.6%. Its much higher income nowadays—more than 4.7% this week—should bolster its diversification power in the stock market’s next downturn.

Why buy anything but Treasury bills?

“‘T-bill and chill’ is working for me now,” commented reader Rachael Steiger. Peter Kranzler was more blunt: “Anyone who lends money to the government for 30 years at 4.7% is nuts. I bought short-term Treasurys [last] week with a 5.4% yield. Why would I take [extra] risk and get [0.7 percentage points] lower yield?”

Why indeed? With short-term Treasurys offering higher yield than some other types of fixed-income assets, “you aren’t really getting paid enough to take any extra risk,” says Bettina Lee, managing director at the Lam Group, an investment-advisory firm in Lake Oswego, Ore.

That, says Lee, means you should overweight T-bills and underweight such assets as bank loans, private credit, high-yield bonds, foreign and emerging-market debt, or even long-term Treasurys at their current levels.

For now, T-bills are hard to beat.

Write to Jason Zweig at intelligentinvestor@wsj.com