Overview
Bonds have traditionally played an important role in diversified portfolios.
They can provide income, help manage volatility, and give investors another asset class alongside stocks and cash.
Over the past several years, the bond market has experienced significant changes. Interest rates increased sharply, bond prices became more volatile, and investors saw periods when stocks and bonds declined at the same time.
Today, yields are considerably higher than they were for much of the last decade.
In a recent episode of Clear Money Talk, Tim Clairmont and Tyler Andrews, CFP®, NSSA®, Wealth Advisor, were joined by Gene Goldman, CFA®, Chief Investment Officer at Cetera, to explore the question: Are bonds finally worth owning again?
Their answer: yes, bonds can be especially attractive in the current environment, depending on the investor’s goals, risk tolerance, time horizon, and overall financial plan.
How Bonds Work
A bond is essentially a loan.
When you purchase a government bond, you are lending money to the government. When you purchase a corporate bond, you are lending money to a company.
In return, the borrower generally agrees to pay interest and return the principal at maturity.
The level of interest usually reflects the amount of risk involved.
Government bonds typically offer lower yields because the perceived likelihood of repayment is higher. Corporate bonds may offer higher yields because investors are accepting additional credit risk.
Bond prices can also change after the bond is issued.
When market interest rates rise, existing bonds with lower rates generally become less valuable on the secondary market.
When interest rates fall, existing bonds with higher rates may become more valuable.
That relationship between rates and bond prices is one of the most important concepts for bond investors to understand.
Higher Yields Have Made Bonds More Attractive
One of the biggest changes in the bond market has been the increase in yields.
Gene discussed how the 10-year U.S. Treasury yield was around 4.75% at the time of recording.
That is significantly higher than the yields available during periods such as 2020, when the 10-year Treasury sometimes yielded around 1% or less.
Higher yields give investors more income while they hold the bond.
They can also provide a stronger return relative to inflation.
Gene explained that when bond yields exceed inflation, investors may earn a positive “real yield,” meaning the income is growing faster than the loss of purchasing power caused by inflation.
That higher starting yield has made fixed income a more compelling part of the investment conversation.
Bonds Can Help Diversify a Portfolio
Bonds can also provide diversification.
Different investments respond differently to economic conditions, interest rates, inflation, and market uncertainty.
High-quality bonds have historically helped reduce portfolio volatility during certain periods of stock-market stress.
That can become especially important as an investor approaches retirement or begins relying on a portfolio for income.
Someone who has spent decades investing heavily in stocks may decide to gradually add bonds as retirement approaches.
An 80% stock and 20% bond allocation, for example, may provide some additional stability while still maintaining significant exposure to long-term stock-market growth.
The appropriate mix depends on the investor’s time horizon, income needs, comfort with volatility, and financial goals.
Yield, Duration, and Credit Risk Matter
The bond market includes many different types of investments.
Investors may encounter government bonds, corporate bonds, high-yield bonds, mortgage-backed bonds, bond mutual funds, ETFs, and other fixed-income strategies.
Understanding a few basic concepts can help make those choices easier to evaluate.
Yield represents the income an investor may receive relative to the bond’s price.
Credit risk reflects the likelihood that the borrower will be able to make its payments.
Duration measures how sensitive a bond’s price may be to changes in interest rates.
Gene gave the example of a bond with a duration of 10. A 1% increase in interest rates could lead to an approximately 10% decline in the bond’s market value, while a 1% decrease in rates could have the opposite effect.
Longer-term bonds generally have greater sensitivity to interest-rate changes.
These factors help explain why two bonds can behave very differently even when both fall under the broad category of fixed income.
Inflation and Interest Rates Shape Bond Returns
Inflation has played a major role in recent bond-market performance.
A bond may continue paying the same amount of interest while the cost of goods and services rises.
That reduces the purchasing power of the income being received.
Higher inflation also influences Federal Reserve policy and market interest rates.
The two-year Treasury yield is often closely watched as an indicator of expectations around shorter-term interest rates.
The 10-year Treasury is commonly used as a benchmark for longer-term borrowing costs, including mortgage rates.
Changes in those yields can influence bond prices throughout the market.
Investors also face reinvestment risk when bonds mature.
A bond purchased today may offer an attractive yield, while the rate available when that money is reinvested several years from now could be higher or lower.
Understanding the interest-rate environment can help investors evaluate those trade-offs.
So, Are Bonds Finally Worth Owning Again?
For many investors, bonds deserve serious consideration in the current environment.
Higher yields can provide meaningful income.
Fixed income can also help diversify a portfolio and provide another source of return alongside stocks.
The appropriate allocation depends on the individual.
Age, retirement timing, income needs, tax considerations, risk tolerance, and the amount of money that may be needed in the near future all influence the decision.
Investors should also understand the specific types of bonds they own, including their yields, duration, credit quality, and maturity.
For some investors, diversified bond funds, ETFs, or professional money managers may provide easier access to a broader range of fixed-income investments.
A useful question to consider is:
What role should bonds play in helping me generate income, manage risk, and support my long-term financial goals?
Watch the full episode of Clear Money Talk for the complete conversation with Tim Clairmont, Tyler Andrews, CFP®, NSSA®, Wealth Advisor, and Gene Goldman, CFA®, Chief Investment Officer at Cetera.
