Is now a good time to add bonds to your portfolio?
For investors looking for yield in the bond market right now, there isn’t a whole lot to go around.
Rates for 10-year Treasurys were at 1.3%, and 30-year yields were still less than 2%—at 1.9%, as of Sep. 9. That’s compared to rates superseding 2.6% and nearly 3% in Jan. 2019, respectively.
“It is a little bit difficult given the environment today—with yields so low,” says Collin Martin, director and fixed income strategist for the Schwab Center for Financial Research. And especially if you are putting new money to work, it takes a strong constitution to choose low-yielding 10-year U.S. Treasury bonds when equity markets keep defying gravity and hitting records (The S&P 500 is up more than 21% since January). That said, it’s precisely because stocks have rocketed so far, so fast, that now may be a good time to buffer the safer part of your portfolio, as some analysts are questioning how much longer the stock market can keep rising. Fixed income is far more stable than the equity market, so it can cushion equity losses, and bonds also offer regular and steady cash flow.
For anyone considering bonds, there are a few factors that have an outsized effect on prices and yields. Here’s what to consider.
Fed policy The Federal Reserve’s timing, particularly on its federal funds rate, will have direct implications on the economy. The Fed embarked on a massive bond buying program in March 2020 during the depths of the first COVID wave, which had the effect of driving bond prices up, and yields down. When they start tapering that bond buying, and raising interest rates (they’ve already indicated they will do so), you can expect to see yields creep up. Investors who purchase long-term debt while the prices are high in an effort to garner yield run the risk of those bonds losing value later on, according to Martin. “It’s longer term bond prices that’ll fall the most,” he says.
Inflation Inflation is a nightmare for bond investors because it erodes the purchasing power of the interest investors earn. “Historically, inflation is not friendly to bondholders,” says Patrick Scheideler, who is the co-founder of fixed income trading software platform MultiLynq. Scheideler notes that inflation typically brings the prices of bonds down. This has yet to play out in the market. The Federal Reserve has said repeatedly it anticipates the inflation we have seen to be transitory, but right now the numbers aren’t great.
Steepness of the yield curve The Treasury yield curve represents the differences in yields between short-term and long-term Treasurys. The steeper it gets, the more attractive it is for investors to park their money in longer-term investments, which inherently carry more risk. Yields on long-term bonds, while higher, are still incredibly low, so it may not be worth it for investors to take the risk. If the 10-year Treasury rate approaches 2%, then it might be worth reconsidering, according to Martin, who doesn’t anticipate the yield can go much higher than that this year.
For investors that do want to purchase bonds now, the most common way to get exposure is through a mutual fund or ETF. In the chance that a bond defaults (meaning that the entity borrowing the money can’t pay the investor back), it can be risky for investors who hold individual bonds. A pooled fund option offers exposure to a series of options without that same level of underlying risk.
For exposure to the general bond market, two of the most popular funds are the Vanguard Total Bond Market ETF (BND), which seeks exposure to the taxable investment-grade U.S. dollar-denominated bond market. That is trading down 1.81% from the beginning of this year. And the Fidelity Total Bond Fund (FTBFX), which uses the Bloomberg Barclays U.S. Universal Bond Index as its benchmark and is down 0.88%.
Inflation skeptics, who think that inflation rates will be more permanent, may want to take a look at Treasury Inflation-Protected Securities (also known as TIPS). These are securities issued by the U.S. government that are meant to protect investors from inflation. However, it’s important to note that TIPS can underperform traditional bonds. Right now, returns are negative, which can be a worthy tradeoff should inflation be ongoing. If it’s not, it can cost an investor. Some of the more popular ways to gain exposure to TIPS are iShares TIPS Bond ETF (TIP), which is up 1.3% this year, or Schwab U.S. TIPS ETF (SCHP), which is up 2%.
Should the Federal Reserve lift interest rates, and long-term yields go up significantly, investors may lose some of that value, as they may only be able to resell the bonds at a discount from the principal value. For this reason, investors may want to think about sidestepping the slightly boosted long-term returns in favor of shorter-term investments, at least for now. Martin, of Schwab, says that investing in bonds below 5-year maturity dates may help investors preserve value. Options here include the SPDR Portfolio Short Term Corporate Bond ETF (SPSB), which is down -0.38% year-to-date, or the Vanguard Short-Term Bond ETF (BSV), which is down -0.87% from Jan.
Investors can also seek yield in corporate bonds. They are inherently more risky, as they’re backed by companies, which could default on their debt. Investors could look at the Vanguard Intermediate-Term Corporate Bond ETF (VCIT) or the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD).
The key takeaway is that investors have options based on their predictions and outlook for the rest of the year and into 2022. “It doesn’t have to be a yes or no decision,” Martin says.
“Coupon”—The coupon rate is the periodic interest that a government, company, or municipality will pay to an investor who lent them money by purchasing a bond. It is based on the face value of the bond, so if an investor purchases a bond, sold on the secondary market, they will still receive that orginal agreed rate, even if the value of the bond has gone up or down.
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