7 key questions about owning bonds today

• Income – If you rely on relatively 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 investment-grade, 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 4.6% yield (as of 5/31/2023), which, while low relative to rates in the 1980s or ’90s, is at the high end of its past 10-year range. This yield is currently lower than the yield on cash as a result of the Fed’s interest rate-hiking cycle, creating an attractive opportunity in short-term fixed income and cash. We would advise investors to complement short-term bonds and cash with longer-duration fixed income to avoid overexposure to reinvestment risk.*

• Stability and the potential to preserve principal – When a bond matures, the investor typically receives back 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 one three-year period of losses since 1980. By comparison, the S&P 500 has been positive 74% 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 begun to moderate in 2023. As the Fed nears the end of its rate-hiking cycle, we expect further upward pressure on yields will be limited. We believe this creates an attractive investment opportunity for both short- and longer-term fixed income.

• Diversification – Bonds play an essential part in a diversified portfolio because they tend to rise when stocks decline, and vice versa. The fixed-income investments in a portfolio can help smooth out returns during times of volatility. We would highlight that expanding portfolios beyond domestic equity and fixed income to include international asset classes has the potential to further enhance portfolio diversification.
  
  Halfway into 2023, stocks and bonds are both up in response to a resilient U.S. consumer, meaningful progress on inflation and a potential end in sight to the Fed’s tightening cycle.

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.

After looking at 41 S&P 500 pullbacks of 5% or more that occurred during bull markets since 1989, we found that 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 the same level of risk as adding cash.

The single best predictor of future returns of high-quality individual bonds is their starting yield. The chart below shows the annual total return of the 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 higher 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.
   
• 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 form the foundation of the bond 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. This results in lower yields and growth relative to other bonds.
• U.S. high-yield bonds are lower-quality bonds, generally rated BB and below. 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. They 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 they may at times outperform U.S. bonds. Those that have exposure to foreign currencies provide an additional source of diversification when combined with U.S. securities. They tend to fluctuate more than U.S. investment-grade bonds, especially those with foreign 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 highest-quality 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.

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 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 decade high of over 4% in October 2022. With meaningful progress made on reducing inflation and the potential for an end to additional interest rate hikes on the horizon, 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 below 0.5% in the last decade from 1.2% in the 1990s and 2.5% in the ’70s. As the population becomes older and more workers exit the labor force, the potential growth rate for consumer spending and economic growth declines, 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 and transparent prices (the so-called “Amazon effect”) have helped keep a lid on inflation in the past 20 years. While the days of below-2% inflation seem distant at the moment, central banks around the world are now acting to bring consumer price growth back to target. We have seen supply chain bottlenecks begin to 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. And there is still $1.8 trillion of negative-yielding debt globally (down from $18 trillion in late 2020). For this reason, foreign demand for U.S. Treasuries will likely remain strong, acting as an anchor against another significant rise in domestic rates.

After peaking at over 4% in 2022, the 10-year Treasury yield has hovered between 3% and 4% for much of 2023. In light of the potential for additional Fed rate hikes, the two-year Treasury yield has pushed higher to over 4.5% in May 2023. We believe this creates an attractive opportunity to complement short-term fixed income and cash with longer-term fixed income.

We see an opportunity to gradually increase your bond maturities (which would mean more interest rate risk) or reduce shorter-duration bonds to position yourself for a potential peak in yields ahead. While the downward pressure from rising yields may abate, we see a potentially softer economic backdrop. This would favor higher credit quality – high-quality issuers with solid balance sheets.

We recommend a neutral allocation to both U.S. and international bonds. Based on our view of the business and market cycles, we recommend a neutral exposure in high-yield bonds and emerging-market debt, which tend to have more exposure to lower-credit-quality issuers but offer higher yields.

• As the 10-year Treasury yield hovers between 3% and 4%, we think the risk/reward for bonds is attractive from an interest rate perspective. Historically, longer-term yields have peaked a few months before the Fed ended its rate hikes. While the Fed has indicated additional rate hikes are likely in 2023, we believe markets have priced this information into current rates.
• 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.
• We believe opportunities are balanced among investment-grade and lower-quality bonds, recommending a neutral allocation to all five of our recommended fixed-income asset classes. High-yield bonds have been the top-performing fixed-income asset class year to date, as a resilient U.S. economy has helped support lower-quality issuers.
• After over a year of central banks raising interest rates around the globe, we believe the risk/reward trade-off between U.S. investment-grade and international bonds is balanced. 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.