BND Or CDs: Which Is Best As Long Bond Rates Begin Dropping?

Investors who entered the market during period after 2009 were told that stocks were far riskier than bonds, so bonds were where they should put the money they might need to spend. Investment advisors put investors who considered themselves financially conservative into portfolios dominated by bond funds. When stocks crashed they explained, those bond funds would provide the cash they could use to buy stocks “on sale.”

Then, this past year, the Federal Reserve’s unexpectedly aggressive rate hikes sent both stock and bond markets reeling. That rise in rates clobbered those investors who had large holdings in bond funds and ETFs, as they saw their principal erode dramatically, while the income paid by these funds did not begin to rise fast enough to make up for the loss in their funds’ NAVs. Worst of all, the drop in the value of their bond funds made it impossible to use bond holdings to rebalance, making it impossible for those who were fully invested to take advantage of the bear market in stocks.

This took a lot of investors by surprise. Let’s look at the reasons why.

Bond Funds Are Not Like Actual Bonds or CDs

When you buy a bond, you know that when it matures you will get back your principal, unless you are buying very risky “junk bonds” issued by companies likely to default. But if you buy a Treasury bill, note, or bond, a AA rated investment grade bond, or an FDIC insured CD, default is not a serious concern.*

If you hold your bonds or CDs in a brokerage, they will display a price each day that fluctuates. This is the price that you could (maybe) get if you sold your bond on the secondary market. But if you hold that bond, that “mark-to-market” price is irrelevant. You always get back the full amount of your investment when the bond or CD matures. And until it does, you also get the interest you were promised when you bought that bond or CD.

The situation is very different with a bond fund. Bond funds do not have a maturity date. The fund buys and sells bonds all the time at the market price. So it matters when their bonds are marked to market. It is that marked-to-market price that determines the NAV of the fund (or ETF). But this constant buying and selling of bonds means that when you buy into a bond fund you have no idea when, or even, at times, if, you will get your invested principal back.

This was not a problem when rates were declining, because when rates decline, the mark-to-market price of the bonds held in a bond fund go up, causing their NAV to rise. But when rates rise, NAVs go down. And that loss can take a decade or more to be made up even if investors continue to hold their shares. Most importantly, the investor has no way of knowing when their NAV will rise back to what they paid for. It is entirely based on the future behavior of interest rates which is unknowable.

Investors in the Vanguard Total Bond Market ETF (NASDAQ:BND) this past year learned a painful lesson about how bond fund prices behave. Let’s look into why so many were taken by surprise.

In 2022 BND Shocked Investors Who Didn’t Understand How Bond Funds Work

The Vanguard Total Bond Market ETF is the largest bond Fund/ETF in the world. Like many other Vanguard ETFs, BND is actually a share class of a mutual fund, the Vanguard Total Bond Market Index Fund (VBTLX). All the share classes of that fund hold $278.6 Billion in Assets. The ETF class alone holds $84.9 Billion.

Over the course of 2022, BND experienced a loss in its NAV that was startlingly similar to that suffered by the S&P 500.

BND Price Performance Full Year 2022

Even if you’re figuring in the dividends BND paid, its total return over the course of still delivered a loss of 11.93%. For investors who had been repeating the mantra “Bonds are for safety,” this was a rude awakening.

But it was also a very understandable one. Shortly after the Vanguard Total Bond Market Index fund began trading at the end of 1986 its NAV relentlessly climbed upwards with only short periods of decline until the end of 2020. It then dropped far more than it ever had during its entire life as a fund.

Vanguard Total Bond Market Index Fund Investors Shares Performance Since Inception

Why BND Rose For So Long

The Fed rate in interest rate in 1989 reached a high of 9.71% which it never neared again. As this Macrotrends chart shows, since that time the Federal Funds Rate that greatly influences all other interest rates has been gradually declining, which short periods of upsurge followed by deeper declines.

Federal Fund Rate 62 Year History

The most important thing you need to know about bonds is that when rates decline, the value of a bond goes up. And when rate rise, it drops. That’s why investors who invested in the Vanguard Total Bond Market Index Fund after 1989 got used to seeing their bond fund’s NAVs rise. Yes, the yield of the fund went down over time, but inflation did too.

Until the financial crisis of 2009 led to the advent of Quantitative Easing–i.e. the Fed taking heroic measures to push bond rates artificially low–the yield of BND was almost always a percent or two higher than inflation. All these factors made BND a very reasonable investment. Best of all, because of that declining NAV, no matter what rates were doing, if investors needed the money they had invested in their bond fund, it was there for them. That did make it seem like “bonds were for safety,” which is the mantra you heard repeated by advisors and otherwise savvy investors in online forums for years.

Safety Stopped When Long-Term Yields Approached 0%

Investors who understand how bond funds work will tell you that for every 1% rise or fall in bond rates, the NAV of a bond fund will fall or rise a percentage that is equivalent to its average duration

Vanguard gives BND’s average duration is 6.5 (years). So if rates go down by 1%, BND’s NAV should rise about 6.5%. And, inversely, if rates rise 1%, BND’s NAV should drop by 6.5%.

BND’s Bond’s Average Maturity Makes the 10 Year Treasury a Good Benchmark

BND holds a lot of long-term bonds, so it is no surprise that Vanguard tells us that its average effective maturity is 8.9 years. That makes the 10 year Treasury bond (US10Y) an appropriate measure by which to predict its movements.

Seeking Alpha reports that the 10 year Treasury bond was yielding .93% at the beginning of January of 2021. By the beginning of 2022 it was yielding 1.53%. And by the end of 2022 it was yielding 3.84%. That represents a gain in yield of 2.31% for 2022 and of 2.91% since the beginning of 2021.

Multiply that duration by those interest rate increases and you can see that you should have expected to see something like a 15% decline in BND’s price last year as Treasury rates rose. And that matches pretty well with the 14.29% loss in NAV we saw above in the chart of its price.

Faulty Assumptions Made Investors Think Their Bond Fund NAV Could Recover Faster Than It Actually Will

It was often explained that if rates did rise, those rising rates would quickly make up for the loss in NAV that investors experienced. Charts were frequently posted and referred to showing how you could recover from a 1% rise in rates in just a few years and that you would be better off, in the long run, when rates rose. Unfortunately, these charts tended to assume there would be a single 1% rate rise, not the steady rise lasting a year or two or three we have actually experienced.

More troubling was that these charts often assume that the investor was reinvesting the dividends paid by their bond fund. But investors who invest for income may be spending that income, especially if they are retirees. Not reinvesting their dividends would greatly increase the time it took for the NAV of their fund or ETF to recover.

The upshot was that anecdotal evidence suggests that a lot of BND investors sold out of BND at its bottom, and moved their money into shorter duration funds, locking in their losses.

Does The Decline in Long Rates of The Past Month Mean It’s Safe to Buy BND Now?

That is the million dollar question. The same bond math that pushed down the NAV of BND when rates rose steeply could cause it to shoot up if they declined quickly again. And long bond rates are declining.

The 10 year Treasury reached a peak on November 7, 2022 when it reached 4.24% and has been coming down slowly since then albeit with occasional surges upwards, but the trend is down. The financial media report that investors continue to ignore the Fed’s guidance and are investing on the assumption that the Fed will slow their rate increases and then, faced with the recession that the financial media insists is coming, start cutting rates again, possibly within this very year.

If that really happened, BND would be a fine investment right now, mainly for the rise in NAV you could experience. But that said, Vanguard tells us that as of December 31, 2022 the average coupon of the bonds in BND was only 2.80%. The most recent distribution yield of the mutual fund version of BND, the Vanguard Total Bond Market Index Fund Admiral Shares (VTBLX), annualized out to 2.79%, which is almost identical to that coupon. (It’s not possible to calculate the distribution yield for the ETF as the price varies throughout the day unlike the case with the mutual fund.)

And the average effective maturity of its bonds was a long 8.9 years, which means that a lot of BND’s holdings will be paying lowish coupons for years to come.

So though BND currently sports a 4.04% SEC yield, that is not the actual income yield you will receive each month if you buy BND now. It will take quite a while for that monthly payment to inch up, and until it does BND does not compete well with other fixed income offerings.

Over time, the distribution yield may rise to the SEC yield, possibly because the price of BND will stay depressed or even drop further. But that it will reach that 4.04% SEC yield is not at all guaranteed. Nor is it guaranteed that rates will continue to drop.

Short term data suggests that inflation is moderating, but Jerome Powell has made it clear that he does not want to make the mistake that Arthur Burns made in the 1970s and declare victory over inflation too soon, only to see it rebound to double digit heights. That inclines me to believe that he will hold rates at the target near 5% the Fed has been talking about for months for a good year or more.

Contrary to popular belief, a 5% rate will not destroy the economic universe. Us old codgers can recall how back in the 1990s 5% was an insultingly low yield that you would get only if you invested in your local bank’s “Christmas Club.” And that was during a period when inflation was running lower than it is now. We also remember that the economy boomed and housing did very well when mortgage rates were closer to 7% than 3%.

I was a happy owner of bond funds through the years when rates gradually declined, but I see no reason to tie up my money for a 2.79% yield when there is still the possibility of losing another 6.5% or more of my invested principal if long rates go up another percent. Especially since there are safer, better yielding options for those looking to invest over a longer term.

Let’s look at them now.

CD Rates Have Picked Up Even As Treasuries Are Declining

Longer Treasury rates have been declining, as we mentioned. As I write this, the 5 year treasury note is only yielding 3.439%. This is still a better yield than you get from BND, and if you buy that Treasury note in a taxable account, unlike the case with BND, your interest is free of state and local taxes.

But there are better options. Brokered CD rates available to U.S. investors at brokerages like Vanguard, Fidelity, and Schwab, tend to lag Treasury yields as they rise, but they also lag them as they decline. So they are currently higher than Treasury yields of the same maturity, even accounting for higher taxation.

The table below shows you the New Issue brokered non-callable CDs that are not callable which you can buy right now on the Schwab brokerage platform. (Note that New Issue CDs can be bought from the brokerage at face value without paying a fee. Secondary market CDs do cost $25/$1000 to buy or sell.)

These rates are also declining now, so if you have a brokerage account and some money to invest, don’t wait. I bought a CD this morning that had only a very limited number of shares left. After I bought those, the highest available yield was .05% less.

Credit Union CDs Offer Even Better High Yield Opportunities

Though they require a bit more work for investors, Credit Union CDs have some advantages over Brokered CDs for U.S. investors, as they can be redeemed by paying an early withdrawal penalty, which gives you some protection from runaway inflation and sharply rising rates. IRA CDs may allow you to withdraw money without penalty. And if you were to die or become severely ill both regular and IRA CDs can often be closed without a penalty. (Consult the terms at the specific institution before investing if these factors are a concern as they can vary.)

Credit Union CDs lag Treasuries even more than brokered CDs, so they have only very recently become competitive with Treasuries and brokered CDs.

You can see all the rates that you qualify for based on your address at DepositAccounts. Right now there are several nationally available 5 year CDs offering rates over 4.5%.

The very best rate available right now is a 4.75% CD is offered by the NASA Federal Credit Union. I have invested in several NASA FCU 49 month CDs over the past 5 years and have had no complaints about their service. Just be aware that there is a 365 day early withdrawal penalty, which with a rate that high makes it unlikely that you will be able to exit the CD without a significant loss.

If you are looking for Credit Union and Internet Bank CDs, it is a good idea to check DepositAccounts’ Blog every few days as there can be some very good deals there, some of which will only be available to people who live in your county or state.

One Last Consideration for Retirees

If you invest for income that you need to spend each month, the interval at which an investment pays out can be very important. BND pays out monthly. So do Credit Union CDs. Many of these Credit Union CDs will also let you take out the interest from your CD each month and not consider it an early withdrawal. Just note, however, that the rate credit unions and banks quote for you are usually rates that assume that the interest is reinvested for the term of the CD (this rate is followed by the letters “APY”). The actual yield is usually a few points lower (the “APR”). So if you intend to take out your interest payment monthly assume you will only get the APR.

Brokered CDs are a mix. None reinvest the interest, which goes into your settlement account at the brokerage. So what you see as the interest rate is what you actually get. Some pay monthly, but most only pay twice a year. Longer maturity Treasuries also only pay out every six months. So for the retiree who plans to spend their income a Credit Union CD might be a better option.

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* It is true that some politicians currently pretend they will force the Treasury to default on its debt in an attempt to get their way. But the havoc this would cause not only for investors but for corporations who are heavily dependent on bond markets and, most importantly for the very wealthy donors who fund political campaigns makes this very unlikely.