Well, stocks actually don’t have drip this year. Nor do bonds. And that's unusual based on history, because many investors used to rely on bonds to help protect their money when the stock market tanked.

Bonds were pretty boring, portfolio-wise, for decades. Outside of a few spicier versions like “junk bonds” or “leveraged loans,” they were lower earning, yet generally stable investments compared to stocks. And in general, interest rates fell for decades — meaning that if you sold a bond before it matured, you likely could have sold it at a gain. Of course, that also meant if you bought new ones over time, your return from the interest was generally lower than before.

But first, let’s review — what are bonds? Unlike stocks, where you own a piece of a company, with bonds you lend money to a company (or government). As the lender, you are paid interest (typically semi-annually) during the period it’s lent out. When the loan period is over (aka, the bond matures), the money you loaned is generally returned. According to the Securities Industry and Financial Markets Association, or SIFMA, the US bond market is the largest in the world, standing at $49 trillion (as of 4Q21), compared to the US stock market estimated at $39 trillion.

Your return from investing in bonds is usually determined at the start of the investment and is driven by the defined interest rate. For example, if you buy a US treasury bond that matures in 10 years with a 4% interest rate (aka coupon rate), that means you lent the US government money for 10 years and will likely make 4% a year to maturity. Now the thing is, interest rates can change. So the value of a bond will fluctuate until it matures with changes in broad interest rates. And the relationship is such that when interest rates go up, the value of bonds go down, and vice versa. That means, if you needed to sell the 10-year bond before maturity, you may sell it for more or less than you paid for it, depending on what happened to interest rates since you bought the bond.

Let’s also get a few other critical bond concepts down. First, duration. It's stated in number of years and measures how much the value of a bond may move when there is a move in interest rates. All things being equal, for every 1% move up in interest rates, the price of a bond with a 10-year duration will move down 10% (and vice versa). In addition, there is the yield-to-maturity, which is the estimated total rate of return, assuming the bond is held to maturity, and takes into account the price paid for the bond. This is the most quoted term for bonds when trading them.

Now back to the bond markets.This chart shows the 10-year US government yields (aka interest rates) since 1962.

Per the chart above, interest rates fell from over 15% in the 1980s to 2.5% or less since 2010. This was generally good for bond values, because when rates fall, bond values rise. Also during that time, debt levels from the US government and companies alike increased. In 1980, the US government’s debt as a share of GDP was about 30%; today it’s closer to 105%. Corporate debt rose, but by less — from 13% to 27% of GDP. Of note, low interest rates make it much easier to borrow and pay for that debt.

Keep in mind, the falling interest rates we’ve seen over the last several decades also helped many stocks. This is because companies could borrow at lower and lower costs over time, helping their bottom line. Meanwhile, cash became less and less appealing to potential stock market investors, as savings account rates fell with interest rates.

Like I said earlier, historically, an investor could have bonds in their portfolios to help weather stock market storms. If you look closely at the chart above, you can see how yields often went higher (bond values fell) in the shaded recession times. As an example, in 2008, the S&P 500 fell -37% while the broad US bond market (as measured by an index called the Bloomberg US Aggregate Bond Index) actually rose 5%. In fact, because of this relationship, a common mix for some investors has been 60% stocks and 40% bonds, with the idea that they would get some stock market upside, but also some cushion on the down side.

However, this year is different. Interest rates have been going higher, causing bond values to fall, just like stocks. The S&P 500 is down -23% this year through October 10, while the US bond market is down -15%. So bonds have not been so helpful this time around. As a result, there are news articles out there calling for “the official end to 60/40.” 

Why are bonds not helping as much this year? Inflation. It’s bad for most assets. The drivers of inflation were initially from COVID stimulus and very low interest rates that turned into demand for goods, right when supply chains jammed up. This year though, inflation has been more widespread and the conflict in Ukraine has exacerbated it with a reduction in supplies of crucial commodities, oil in particular.

Interest rates, that drive bond returns, can be made up of a few things:

1. Rates on cash (often called the “risk free rate”), which the Fed has been increasing 

2. Inflation

3. Time (how long the borrowing goes on for, related to “duration”) 

4. Sometimes credit risk (whether you can get paid back or not)

So as inflation has been going higher, the Fed has been raising what some regard as the risk free rate, to try to make it more costly to borrow, reduce demand, and eventually reduce inflation. Thus, interest rates have gone higher, making bond values fall.

If a traditional mix of stocks and bonds isn’t working, what is an investor to do in this environment? 

Timing the market is hard, so really knowing your time horizon and how much risk you can tolerate can be key. However, in an environment like this, some areas that have had positive returns this year are cash and commodity related investments. Here’s why:

• Cash is at least not going down in value, and the rates you get for it are slowly increasing, thanks to the Fed.

• Commodity price increases, like rising prices in oil, have been leading to rising values of companies that sell them. So stocks of companies in the energy and agricultural sectors are generally positive this year. 

• Of course, there have been opportunities in other sectors: Healthcare is a unique sector that mostly includes large dividend payers as well as potentially revolutionary but risky companies in biotech. Lower stock prices have seemingly been driving mergers and acquisitions in this space this year. 

The big question for investors is, will rates now be higher for longer, or said another way, are we entering a new regime of a bond bear market? I think there could be a time when interest rates stop going up and bonds become attractive again, but it may be a while — I try not to say never. 

So bonds may not be dripping right now, but understanding them is key to understanding the current investment climate we are in. And that’s not cheugy.

Dividends are not guaranteed and must be authorized by the company’s board of directors.

Sources: SIFMA, Board of Governors of the Federal Reserve System, Federal Reserve Bank of Dallas, Federal Reserve, Bloomberg. Chart: 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, October 10, 2022.