Step Aside Girl Math, Let’s Talk Bond Math

Author: John Owens CFP®. John is the Director of Financial Planning here at BKFi.

Summary: John discussed the #girlmath TikTok trend and how we can apply it to the misunderstood and frankly boring bond market.

The latest TikTok trend has been discussing Girl Math, a financial concept with a strong connection to mental accounting and how we justify spending - but perhaps little bearing on reality. We’re not going to get further into Girl Math here today, but we are going to take some time discussing Bond Math - which has not been a TikTok sensation (sadly). 

We often get questions about portfolio bond allocations. While many of our clients are younger, we do find it helpful in most of our portfolios to have a dedicated fixed-income (bond) position. This can be comprised of a variety of funds, including municipal bonds, aggregate US bonds, and even some international bonds. 

In line with our investing philosophy, we’re not trying to identify the best bond manager whose “crystal ball” can attempt to predict where bonds will go in the future and which ones to buy and sell - that’s an expensive way to invest that often produces mixed results. We rather use low-cost index funds that represent large chunks of the bond market. 

In recent years, however, we’ve been asked quite a few questions about bonds and how they work. In particular, as interest rates have risen, bonds have been negatively affected. 

Bond math works something like this - if you buy a bond (or, in our case, a basket of bonds via an ETF) that yields 3% interest, you assume you’ll get 3% per year from that bond, and your principal back at the end of some period - let’s say 30-years. 

But today, maybe new 30-year bonds are paying 5% interest instead of 3%. That means if you want to sell your 30-year 3% bond, you’ll need to discount it - because why would someone buy a 3% bond when they can get 5% somewhere else? They wouldn’t.

We can see here that as interest rates go up, the value of the bonds you hold goes down. This has been evidenced in many bond funds over the past 2-years of rate hikes. From October 2021 through late September, for example, BND - the ETF for the Vanguard Total Bond Market Index, has dropped over 18% as interest rates have risen. 

The bond market looks different today, however. BND, for example, is currently sporting a 4.75% yield and an average “duration” of 6.4 years. Duration is a key ingredient of bond math.

What duration tells us is the sensitivity of bonds to fluctuations in interest rates. So, with many indications being that the Fed is slowing down its rate hiking agenda as inflation continues to fall, we may be heading to an era where rates stay steady - or even drop if the economy were to slow down. 

And so I’ve been asked, why should I hold bonds? Well, in this example, you can earn a yield of 4.75%, and if the economy were to pull back and interest rates were cut - you’d see those bonds appreciate. 

But how much would they appreciate? That’s where duration comes in. Sticking with our example, you hold a bond fund with a 4.75% yield and a duration of 6.4 years. The economy pulls back, and the fed cuts rates by 1%. That bond would be expected to appreciate in price by 6.4% as duration measures the impact of duration on bond value. 

So, while there’s currently a lot of attention on high-yield savings accounts paying a similar rate to bonds, it’s important to remember that if rates drop, the only impact on your HY savings will be smaller interest payments, while the bonds in your portfolio stand to benefit from price appreciation in a declining interest rate environment. And that’s just one of the reasons why we like to own some bonds. #BondMathOverGirlMath