7 key questions investors should ask about owning bonds today

• Income — If you rely on stable, continuous payments or are planning for future expenses, you can build an investment strategy around the interest payments a fixed-income portfolio can generate.
  
  We believe high-quality, intermediate-term bonds (as represented by the U.S. Aggregate Bond Index) should be a core holding within a fixed-income portfolio. High-yield bonds (as represented by the Bloomberg US High Yield 2% Issuer Cap) might provide more potential income, but because they tend to move in the same direction as stocks, that higher yield comes with higher risk.
  
  U.S. investment-grade bonds offer a 4.4% yield (as of 8/26/2024), which, while low relative to rates in the 1980s or ’90s, is at the high end of its past 20-year range. The current yield on cash exceeds the yield on investment-grade bonds, as the Fed hiked interest rates to combat elevated inflation in 2022 and 2023. We would advise investors, where appropriate, to complement short-term bonds and cash with longer-duration fixed income to avoid overexposure to reinvestment risk, particularly as the Fed normalizes policy over the coming years.*

• Stability and the potential to preserve principal — When a bond matures, the investor typically receives their original investment, absent any defaults. If you invest in a packaged product, such as a mutual fund or exchange-traded fund (ETF), you have no guarantee you’ll recoup your original investment. But historically, high-quality bonds have been less volatile than stocks and generated positive total returns over the medium and long term. While past performance is not a guarantee of future results, the U.S. Aggregate Bond Index has suffered only two three-year periods of losses since 1980. By comparison, the S&P 500 has been positive 75% of the time over the same time frame.
  
  2022 was challenging for bond investors. U.S. investment-grade bonds returned -13% as the Fed aggressively hiked interest rates in an effort to combat inflation. Inflation has since moderated, and we believe the Fed will normalize its policy rate over the coming years, which could be supportive to both equity and bond market returns.

• Diversification — Bonds play an essential part in a diversified portfolio because they tend to rise when stocks decline, and vice versa, helping smooth out returns. While stocks and bonds both sold off sharply in 2022, bonds declined less than stocks, providing some diversification benefit to balanced portfolios.

  2023 saw strong returns in both equities and bonds, with the S&P 500 rising by over 20% and investment-grade bonds gaining over 5%.

When economic growth slows, fixed income can become more attractive as a source of returns and liquidity. We saw this in 2020 and during past recessions. But stocks don’t have to be in a bear market for bonds to shine.

Looking at 41 S&P 500 pullbacks of 5% or more that occurred during bull markets since 1989, investment-grade bonds generated positive returns 83% of the time as stocks fell. By comparison, gold was positive 49% of the time, followed by the utilities sector (39%), a broad basket of commodities (25%) and the consumer staples sector (7%).

Cash can also help reduce portfolio risk. But because bonds offer diversification, adding them to a stock portfolio may generate better returns for a similar level of risk as adding cash.

The single best predictor of future returns of high-quality individual bonds and bond funds is their starting yield. The chart below shows the annualized five-year forward return of the Bloomberg U.S. Aggregate Bond Index. Over five-year periods, it has tended to match its starting yield. High starting yields are likely to produce high returns, and low starting yields low returns.

While bond prices may fluctuate in the short term, this volatility doesn’t play a big role in long-term returns, which are primarily determined by the coupon and principal payments (absent defaults). The upside to the recent decline in bond prices is that yields are now more attractive, suggesting improved future returns for newly invested money.

Different fixed-income investments have their own unique drivers, of course. But the two most important determinants of performance are interest rates and credit quality.

• Interest rates determine the income that can be generated from a bond and affect its value as well. Bond prices typically fall when rates rise, and vice versa. The longer a bond’s maturity, the more sensitive its price is to interest rate changes. Duration (also expressed in years like maturity) estimates the sensitivity of prices to interest rate movements. When rates are rising, short-term bonds tend to outperform bonds with longer duration. But when rates are falling or stable, long-term bonds tend to do better because of their higher sensitivity to changes in rates and their typically higher yield.d
   
• Bonds of lower credit quality tend to be more volatile than bonds of higher credit quality. But they also typically carry higher interest rates, which can mean more income for a portfolio. The difference in yields between higher-quality bonds (such as a government bond) and lower-quality bonds (e.g., BB corporates) is called a credit spread. When spreads narrow, credit risk is rewarded, and lower-quality bonds tend to outperform. However, the opposite happens when spreads widen, typically when the economy slows or contracts.

Your portfolio’s balance between equity and fixed income should be tailored to your risk and return profile. Your financial advisor can help you determine (or reassess) the portfolio objective that’s right for you.

Whether you invest in individual bonds or packaged bond products, we believe in diversifying a bond portfolio across the main fixed-income asset classes listed below. Then you can work with your financial advisor to diversify across sectors, maturities, issuers and bond categories (government, municipal, corporate).

• U.S. investment-grade bonds are generally rated AAA, AA, A and BBB. With their focus on high quality and current income, these bonds should form the foundation of the fixed-income portion of a portfolio. They tend to rise when stocks fall, reducing the overall risk in a portfolio when combined with stocks, and tend to be lower in risk. The diversification benefits relative to stocks and lower volatility relative to other fixed-income asset classes typically result in lower yields relative to ther bonds.
• U.S. high-yield bonds are lower-quality bonds, generally rated BB and lower. They can add diversification and increase a portfolio’s overall income. They tend to move in the same direction as stocks, so they don’t usually diversify stocks as well as U.S. investment-grade bonds. High-yield bonds provide higher income because they tend to be higher in risk, which means they tend to underperform U.S. investment-grade bonds in poor credit environments.
• International bonds are higher-quality bonds that may include exposure to foreign currencies. They add diversification because performance of international bonds may at times differ from that of U.S. bonds. Additionally, those with foreign currency exposure tend to fluctuate more than U.S. investment-grade bonds. For this reason, we generally recommend investors access international bonds through a diversified product, such as an ETF or a mutual fund, that hedges currency exposure.
• Emerging-market debt is lower-quality fixed income. Exposure to emerging-market debt can provide diversification benefits and enhance a portfolio’s income potential. While it provides higher income due to higher risk, it tends to underperform international investment-grade bonds in poor credit environments.
• Cash is the lowest-risk and most liquid investment. It is a distinct asset class within fixed income, providing stability and serving as a source for future investment. But don’t confuse this type of cash with spending cash or emergency cash. It is meant to protect principal and will generally have a very low yield, meaning it can lose purchasing power over time due to inflation.

Bond ratings generally represent the rating company's opinion of the bond's ability to meet its ongoing contractual obligations. Ratings are estimates and should be one of many factors in evaluating a fixed-income investment. Ratings should not be considered an indication of future performance.

Beyond the asset class level

• Maturity — One long-term strategy is to build a bond ladder by investing across maturities. Laddering helps manage risk and doesn’t depend on rising or falling interest rates for success. It can also help smooth wide swings in your income and principal. But keep in mind that bond laddering doesn’t ensure a profit or protect against loss. This table shows our general maturity guidance.

• Muni bonds — Municipal (or muni) bonds are issued by state and local governments to pay for public projects. They’re different from other bonds because their interest income is typically exempt from federal income tax. In addition, muni bonds issued within your state may be exempt from state and local taxes. While a taxable bond may offer a higher rate, the interest income may end up being less after you’ve paid taxes on it. Your financial advisor can help you calculate what’s known as the tax-equivalent yield.

Your bond’s coupon payments don’t change when interest rates rise. But bond prices fall as new bonds are issued with a higher interest rate.

Investors with a longer-term time horizon can benefit from higher yields. Maturing short-term bonds can be reinvested into newly issued bonds with higher coupons to provide more income.

The following example illustrates this concept. This hypothetical fixed-income investment initially declined because of a 2% rise in yields in year 1. After 10 years, though, it ended up higher when compared to a scenario where rates stayed unchanged.

This example illustrates that bond investors can benefit in the long term from rising rates, but only if they stay invested as appropriate relative to their investment goals, time horizon and risk tolerance.

Around the world, interest rates have trended downward since the early 1980s. But after record lows in 2020, 10-year Treasury yields rose to a 16-year high of 5% in October 2023. With meaningful progress made on reducing inflation and the Fed likely to normalize policy over the coming years, we would expect limited upward pressure on yields from current levels. Many of the factors that caused interest rates to fall over the past 40 years are still with us, albeit to a lesser extent:

• Demographics — Over time, population growth among developed countries has slowed and even stagnated in some cases. U.S. labor force growth has fallen to around 0.5% in the past decade, compared with 2.5% in the 1970s. As the population becomes older and more workers exit the labor force, the potential growth rates for consumer spending and economic growth decline, exerting downward pressure on yields. Also, the rise in life expectancy means people need to save more for longer retirements, which increases the supply of savings and demand for bonds.
   
• Deflationary forces — Disruptive technologies, globalization and transparent prices (the so-called “Amazon effect”) have helped keep a lid on inflation in the past 20 years. While the days of inflation below 2% seem distant at the moment, central banks around the world have acted to bring consumer price growth back to target and are now easing policy as inflation has moderated. We have seen supply chain bottlenecks clear and normalize. At the same time, technology and the potential productivity gains are likely to continue to exert downward pressure on prices.
   
• Low foreign yields — While yields have risen around the world over the past year, U.S. interest rates remain higher than in most developed countries. For example, the 10-year yield on a Japanese government bond was still below 1% at the end of August 2024. For this reason, foreign demand for U.S. Treasuries will likely remain strong, acting as an anchor against another significant rise in domestic rates.

As mentioned above, 10-year Treasury yields surged to 5% in October 2023, a level not seen since 2007. The run-up in long-term yields was driven by resilient economic growth that exceeded market expectations. While yields have since pulled back, they remain elevated relative to levels seen over the past two decades.

We believe the current environment creates an attractive opportunity for long-term fixed income as inflation moderates and economic growth slows from above-trend rates. This will likely support a multiyear rate-cutting cycle from the Fed, which could lead to lower long-term yields.

While we believe opportunities are attractive for U.S. investment-grrade bonds, our expectation for moderating but healthy economic growth, lower inflation and a multiyear Fed easing cycle creates, in our view, a more favorable backdrop for equity markets. As part of our opportunistic asset allocation guidance, we recommend clients overweight U.S. large- and mid-cap stocks. We also believe opportunities are attractive in emerging-market debt relative to U.S. high-yield bonds.

With yields elevated relative to recent history, we think the risk/reward for bonds is attractive from an interest rate perspective. Our view is that the Fed is poised to embark on a multiyear easing cycle, which could lead to limited upward pressure on yields from current levels. Therefore, we recommend investors moderately extend duration in U.S. investment-grade bonds relative to the Bloomberg U.S. Aggregate Bond Index. We also recommend a neutral allocation to investment-grade credit as moderating but healthy economic growth should create a supportive backdrop for credit conditions.

The higher yields suggest improved forward bond returns. We would advise investors to avoid over-allocating to cash and short-term bonds, and maintain balance across maturities in their fixed-income portfolios.

As part of our opportunistic asset allocation guidance, we recommend investors underweight U.S. high-yield bonds in favor of emerging-market debt. Emerging-market debt has higher interest rate sensitivity and credit quality than U.S. high-yield bonds, which could lead to outperformance in emerging-market debt if yield drift lower, as we expect. Additionally, credit spreads within U.S. high-yield bonds are at historically tight levels. We see limited scope from credit spreads to compress from current levels, potentially dampening the return potential of U.S. high-yield bonds.

We believe opportunities and risks are balanced within international bonds. We recommend a neutral allocation as part of our opportunitistic asset allocation guidance. International bonds have a higher duration than U.S. investment-grade bonds and could stand to benefit as central banks approach the end of their rate-hiking cycles.