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Stocks and bonds both get clobbered this time. Here's what's behind the double whammy

Stocks are down more than 20% this year. Usually when that happens bonds hold their value. But right now both are down sharply, hurting retirees and people saving for college in 529 plans.

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A screen on the trading floor displays the Dow Jones Industrial Average at the New York Stock Exchange in September. Stocks have kept falling since then and hit their low for the year on Friday.
A screen on the trading floor displays the Dow Jones Industrial Average at the New York Stock Exchange in September. Stocks have kept falling since then and hit their low for the year on Friday. Andrew Kelly/Reuters

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."

Deborah McDaniel at her home in Bremerton, Wash. She retired 2 years ago and has been watching the stocks and bonds in her retirement account fall in value.
Deborah McDaniel at her home in Bremerton, Wash. She retired 2 years ago and has been watching the stocks and bonds in her retirement account fall in value. Deborah McDaniel

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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Transcript :

AYESHA RASCOE, HOST:

The stock market fell sharply again last week - down nearly 23% so far this year. And anyone with a retirement or college savings account is getting hit with a double whammy. Usually when stocks drop, bonds hold their value or even go up. Right now, both are getting clobbered. NPR's Chris Arnold explains.

CHRIS ARNOLD, BYLINE: 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 volatile. And bonds are more like the slow, steady turtle paying you a fixed, predictable rate of return. But this year, both stocks and bonds have been falling in value.

DEBORAH MCDANIEL: These last couple months have actually been really brutal.

ARNOLD: Deborah McDaniel is 69 years old and lives in Bremerton, Wash. She retired two years ago. She's got a mix of stocks and bonds in her 401(k), which she thought was the responsible and safe approach, but...

MCDANIEL: It got hammered down about, I want to say, like 25% over the last 18 months-ish.

ARNOLD: Laughing about it's easier than crying. But that's brought the value of her retirement account down from more than $500,000 to around 400,000. That's about all she has besides Social Security. So she finds herself thinking, if this goes on much longer...

MCDANIEL: Oh, maybe I need to find a job again at 69. Not something I'd relish doing.

ARNOLD: So here's what's happening. In normal times, bonds are safer investments than stocks. And not only that - their prices can rise in value when stocks crash. So they soften that blow. But not this time.

DAVID KOTOK: This is one of those rare years when both bonds and stocks work against the investor.

ARNOLD: David Kotok is the chief investment officer of Cumberland Advisors. He says usually, when there's worry about a recession, the Federal Reserve would cut interest rates to boost the economy.

KOTOK: But this time, the Federal Reserve has a different problem.

ARNOLD: Inflation is the problem, the worst in 40 years. So instead of cutting rates, the Fed is raising them to try to slow down the economy. So rates are rising, and that's what's pushing down bond prices. Rick Miller is an economist who runs a financial planning business outside Boston.

RICK MILLER: The reason that bonds drop in value is that interest rates rise.

ARNOLD: So, OK, here's how this works. Remember, bonds are those slow, steady turtles. So let's say you own a bunch of those turtles.

MILLER: Your turtles have numbers on their backs.

ARNOLD: Let's say they have twos on their backs because they're paying you 2% a year on your investment. They keep doing that, guaranteed. That's how bonds work. But new bonds are always getting issued. And so when interest rates rise, now people can buy bonds that pay a higher interest rate back to investors, say 5%. That's a lot more money. They're like faster, better turtles. So now if you want to sell your old ones, that's a problem.

Is it kind of, like, nobody wants to buy my crappy slow turtles?

MILLER: Well, they can buy those speedy, nifty, new five turtles. So why are they going to want your slow two turtle? And 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.

ARNOLD: That is why your bond fund has fallen in value. Basically, you have to cut the price to sell it, or nobody wants it. But - and this is really important - your bonds, even though on paper the price is lower if you want to sell them - they're still paying you the same amount of money as before, say 2% a year on whatever you invested.

MILLER: Your turtle's not dying. Your turtle is not even sick, right? It's just a two.

ARNOLD: So one takeaway is don't panic and sell all your bonds. Just stick with your 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, if she doesn't sell them...

MILLER: It should still be generating $10,000 a year, that bond fund, that bond portfolio.

ARNOLD: Even if it's gone down in price, it still pays her the same amount of money. And that's reassuring to McDaniel.

MCDANIEL: It's good to know that my entire portfolio hasn't tanked.

ARNOLD: The problem for retirees, of course, is that many do have to sell some bonds in their retirement account to pay for expenses. So a lower price does hurt then. On the other hand, if you're still working and stashing money away, the bonds you buy now will be paying more money for years to come. Chris Arnold, NPR News. Transcript provided by NPR, Copyright NPR.