It's been a wild ride in the bond market. Treasury yields have whipsawed over the last two years, with the 10-year Treasury yield touching 5% in October 2023, only to fall to the 3.8% area by the end of August 2024. Investors wondering if they've missed the opportunity to earn attractive yields should keep in mind that yields are still generally higher than they were for the 10-year period following the global financial crisis.
There may be some confusion regarding how to actually invest, given how large and complex the bond market is. Below we'll address four key points about bond investing, ranging from "how" to invest to "why now?"
1. Bonds for income and capital preservation
These are two of the key reasons to own high-quality bond investments. Most bonds make semiannual interest payments that are known in advance based on a percent of the bond's par value. A missed interest payment generally triggers a default for the issuer, whereas stock dividend payments are discretionary and can be raised, lowered, or eliminated based on the outlook for the company. Defaults for highly rated investments tend to be rare, however; default risk is highest for investments with sub-investment-grade, or "junk," ratings.
Bonds also have fixed par values and maturity dates, so barring a default, investors know in advance what they'll receive and when.
Bond prices can still rise and fall in the secondary markets, which might catch investors off guard because bonds are often considered "safe" investments. Bonds have interest rate risk, so their prices can rise and fall with the changing interest rate environment, as the chart below illustrates.
Shown below is the price of a Treasury note that matured in August 2024. It was issued in August 2014 at its $1,000 par value—meaning it was a 10-year note when issued—and matured at its $1,000 par value. As you can see, it was a bumpy ride along the way, illustrating that even high-quality investments like U.S. Treasuries can experience ups and downs. Yet the Treasury note matured at its par value in August 2024, meaning the principal was preserved, while still paying 2.375% annually to bondholders. Holding bonds to maturity can help investors "look through" any potential price changes, as those price increases and decreases are ultimately unrealized. Keep in mind that this illustration is for one individual bond. Bond mutual funds and ETFs generally don't have set maturity dates or par values, so there are additional considerations for investors when deciding what approach is most appropriate.
2. Start with core bonds and add lower-rated investments, depending on your risk tolerance
The bond market is large and complex, with different types of bonds with varying degrees of risk. It can be difficult to know where to even start.
We suggest most investors first focus on "core" bonds, or high-quality bonds, like U.S. Treasuries, certificates of deposit, agency mortgage-backed securities, investment-grade corporate and municipal bonds, as well as Treasury Inflation-Protected Securities. These generally have low to moderate credit risk, depending on the investment, and tend to offer more diversification benefits when combined with stocks in a portfolio compared to bond investments with more risk. Think of core bonds as the "ballast" to your portfolio. We suggest they make up the bulk of your fixed income holdings.
Over the past 10 years, U.S. Treasuries have had a negative correlation with the S&P 500® index, while other high-quality investments like agency mortgage-backed securities, municipal bonds, and the Bloomberg U.S. Aggregate Bond Index have had relatively low correlations. Riskier investments at the bottom of the chart below have high correlations with U.S. stocks, so if the stock market is falling, it's likely that these investments are as well.
After building a base of core holdings, investors may consider adding "aggressive income" investments like those highlighted in the table below. These investments come with greater risks—like the risk of default—and any allocation should be in line with an investor's risk tolerance. These investments should always be considered as a complement to core bond holdings, not a substitute.
3. Higher yields come with higher risks
The higher yields that aggressive income investments offer may be tempting, but they come with more volatility and larger potential drawdowns. The chart below compares the average annualized total returns with the average annualized standard deviation (a measure of risk) between many fixed income asset classes. The Y axis represents the annualized total returns—the higher the dot, the higher the average return. But it also shows that higher returns tend to come with more risk, as the X axis illustrates. A higher standard deviation means more volatility, so investors reaching for higher-yielding investments need to be ready to ride out the ups and downs.
Riskier investments like high-yield bonds and preferred securities also tend to have higher correlations with stocks, so they don't provide many diversification benefits to an overall investment portfolio. A high correlation means that their total returns tend to move in the same direction as stock total returns. That can be a good thing when stock prices are rising, but when stocks are falling they tend to fall as well.
High-yield corporate bonds have low credit ratings and have higher default rates than those with investment-grade ratings, so when the economic outlook deteriorates, they tend to underperform. Corporate profits tend to suffer in a slowing economic environment, meaning it could be more difficult for low-rated corporations to remain current on their interest payments or even repay a maturing bond. Long-term investors willing to ride out the ups and downs can still hold high-yield bonds (or bond funds) in moderation given their relatively high yields currently. However, there may be better opportunities down the road should economic growth slow—or worse, a recession hits—pulling spreads to a more attractive level.
4. No one rings a bell at the top
When yields hit their peak, they rarely stay there for a sustained period of time. The recent decline in Treasury yields suggests that trend continues.
Over the last 30 years, the 10-year Treasury yield tended to fall once it hit its peak, and that trend appears to be intact today. After touching 5% in October 2023, the 10-year Treasury yield has whipsawed since then, falling below 4% in December 2023, then back to 4.7% last April, and then back below 4% at the end of August. We believe that 5% yield was the cyclical peak.
The risk/reward of extending duration is less attractive now that yields have fallen. For bond investors, the outlook remains positive but the plunge in yields has reduced some of the opportunity for gains. Investors should favor a "benchmark" average duration, rather than an “above benchmark” average duration. Bond ladders can still make sense for long-term investors but expect some volatility.
Although the 10-year Treasury yield is below its recent peak, it's still at the high end of the post-financial crisis trading range. Aside from the last two years, the 10-year Treasury yield hadn't touched 3.7% since 2011.
Waiting for yields to rise back to their recent highs is also an attempt to time the market, which is something we rarely suggest for long-term investors. Just as we wouldn't suggest a stock investor wait for the market to bottom—potentially missing out on gains if the bottom already happened—we don't suggest investors wait for the perfect time to invest. Yields for high-quality investments are still at their highest levels in years, so we suggest investors take advantage by considering bonds today.
What investors can consider now
Despite the recent decline in bond yields, we still see opportunities for investors. We prefer high-quality fixed income investments, like the "core" bond segments mentioned above. We're cautious on the riskier parts of the market over the short run mainly due to the low relative yields they offer. While long-term investors who can ride out potential ups and downs can consider the riskier parts of the market, like high-yield bonds, in moderation, there may be better entry points down the road.
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Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Lower rated securities are subject to greater credit risk, default risk, and liquidity risk.
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Treasury Inflation Protected Securities (TIPS) are inflation-linked securities issued by the US Government whose principal value is adjusted periodically in accordance with the rise and fall in the inflation rate. Thus, the dividend amount payable is also impacted by variations in the inflation rate, as it is based upon the principal value of the bond. It may fluctuate up or down. Repayment at maturity is guaranteed by the US Government and may be adjusted for inflation to become the greater of the original face amount at issuance or that face amount plus an adjustment for inflation. Treasury Inflation-Protected Securities are guaranteed by the US Government, but inflation-protected bond funds do not provide such a guarantee.
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