A Guide to Navigating the Bond Market

The past decade has been a strange time for bond investors. Despite the potential benefits of bonds—including capital preservation, diversification, income, and tax benefits—historically low interest rates have lately undercut their appeal, particularly where income is concerned. This has led many investors to wonder, "Why bother with bonds?"

But as the Federal Reserve embarks on a new cycle of interest rate hikes, the yields bond investors have so desperately craved may finally be within reach.

"Until recently, investors in search of meaningful income have had to venture off the beaten path, often into riskier territory than is appropriate," says Kathy Jones, Schwab's chief fixed income strategist. "This new wave of rate hikes might finally allow them to generate the income they seek without having to assume undue risk."

Even those who don't have immediate income needs might want to revisit their bond allocations. "Nearly every investor should have some bonds in their portfolio,” Kathy says (see "Bond buying guide"). “But not all bonds are alike, so you want to be sure the ones you hold aren't too risky—or too safe—for your needs."

Let's look at the different types of core and noncore bonds, their risk profiles, and how higher rates might affect them.

The core of your bond portfolio should comprise holdings that help offer diversification, stability, and a reliable source of income, including U.S. Treasuries, municipal bonds (a.k.a. munis), and investment-grade corporate bonds. However, each of these bread-and-butter holdings has its own unique characteristics and response to rising interest rates.

What makes them unique: Issued by the federal government, U.S. Treasuries—which come in three varieties (see "Terms of engagement")—are among the safest available investments because of the lack of default risk. (Unfortunately, this also means they have among the lowest yields, even if interest income from Treasuries is generally exempt from local and state income taxes.) "If you don't want to lose money, you buy Treasuries," Kathy says.

The effect of rising interest rates: As the Fed raises interest rates, Treasury yields also rise. "This is something we've been waiting for years to have happen," Kathy says. With yields poised to increase further, Kathy favors shorter-term Treasuries (bills and shorter-term notes) until rates level off and investors can lock in higher yields on longer-term issues.

What makes them unique: Interest earned on the majority of munis—which generally fall into one of two categories (see "Terms of engagement")—is exempt from federal income tax, and may be exempt from state and local taxes if you live in the issuing state. Because of those tax advantages, munis typically pay lower coupons than investment-grade corporates (see below).

The effect of rising interest rates: Investors have shown strong demand for all tax-efficient investments in recent years, driving up muni prices and pushing down their yields. "With rates moving up, investors may want to consider investing in slightly longer-term munis in order to capture the additional yield," Kathy says.

What makes them unique: Corporate bondholders typically receive monthly, quarterly, or semiannual interest payments (which are subject to federal and state income taxes). Investment-grade corporate bonds are issued by companies with credit ratings of Baa/BBB or above and therefore have a relatively low risk of default. That said, even investment-grade corporates carry a higher risk of default than Treasuries and munis, which is why they also offer slightly higher yields.

The effect of rising interest rates: As interest rates rise, companies will need to pay higher yields to compete with Treasuries. While increased payouts can be compelling, greater borrowing costs can eat into a company's profits and erode its financials—especially for those at the lower end of the investment-grade spectrum. In an environment of rising interest rates, Kathy recommends sticking with highly rated issuers and opting for short-term bonds until the current cycle of interest rate hikes abates and investors can lock in higher yields on longer-term issues.

Sometimes it makes sense to assume more risk in exchange for higher yields. However, so-called noncore bonds—including high-yield corporates, emerging-market and international bonds, mortgage-backed securities, and Treasury Inflation-Protected Securities—should generally make up only a small portion of your total portfolio to minimize unnecessary risk.

What makes them unique: High-yield corporates are issued by companies with credit ratings of Ba/BB or below and therefore have a relatively higher risk of default. To compensate for that added risk, they tend to pay coupons that are often double or more than those of their higher-quality peers.

The effect of rising interest rates: As interest rates rise, high-yield issuers will have to offer even higher coupons to attract investors, putting further strain on their balance sheets. "High-yield corporate bonds are the most vulnerable to default—and likely the most volatile—in an economy that's slowing due to rising interest rates," Kathy says. "That doesn't mean you should avoid them entirely, but be sure you're being adequately compensated for the risk you're assuming." 

One way to do that is to check that the bond's credit spread—that is, the difference between its yield and that of a Treasury bond of similar maturity—is near or above the long-term average. For example, if a high-yield bond is yielding 6.5% and a Treasury is yielding 2.5%, the spread is 4%. You can then compare that number with the average high-yield credit spread published by The Federal Reserve Bank of St. Louis.  

What makes them unique: Unlike U.S. debt, which is backed by the full faith and credit of the U.S. government, emerging-market and international bonds (see "Terms of engagement") carry economic, political, and social risks. Moreover, investing internationally carries currency risk; a change in the exchange rate between the currency in which the bond is issued and the U.S. dollar can increase or decrease your return.

The effect of rising interest rates: Many central banks in emerging markets have been raising rates since spring of last year to combat high inflation, and there are significant risks due to shrinking liquidity. "For investors who can ride out the volatility and stay the course, emerging-market bonds may offer higher yields over U.S. bonds in the long run," Kathy says. Yields for international bonds in more developed countries, on the other hand, are relatively low compared with the U.S. and therefore may not be worth the additional risk, though central banks in those countries have also announced rate hikes for 2022.

What makes them unique: Unlike most bonds, mortgage-backed securities (see "Terms of engagement") don't make a lump-sum principal payment at the bond's maturity. Instead, monthly payments to bondholders consist of both interest and part of the principal (as borrowers pay back their loans), which can vary from month to month and create irregular cash flows. What's more, prepayment of mortgages can cause mortgage-backed securities to mature early, cutting short an investor's income stream.

The effect of rising interest rates: As interest rates increase, so do the yields on newly issued mortgage-backed securities. However, holders of existing mortgage-backed securities are likely to see their incomes decrease. That's because higher rates generally mean a reduction in both prepayments and refinancing. As a result, bondholders typically receive less principal in each payment, extending the life of the bond and saddling investors with a lower-yielding investment in a rising-rate environment.

What makes them unique: When inflation quickens, a TIPS' principal value is adjusted up; when inflation slows, a TIPS' principal value is adjusted lower. Like other types of Treasuries, TIPS are backed by the U.S. government. Interest is paid based on the adjusted principal every six months, and at maturity, investors receive either the original or adjusted principal—whichever is greater.

The effect of rising interest rates: TIPS have been among the best-performing fixed-income investments in recent years as investors anticipated rising inflation. But with the Fed laser-focused on reducing inflation, Kathy says there could be less demand and lower performance going forward. "In this environment of rising rates, a strong dollar, and liquidity concerns, it's probably wise to limit your exposure to these particular securities."

During Fed tightening cycles, short-term rates tend to move up in tandem with Fed rate hikes, whereas longer-term bond yields stabilize or fall. Therefore, it may be best to keep your average portfolio duration—a measure of interest rate sensitivity—low in the near term. However, investors who take a buy-and-hold approach could gradually add a small allocation to longer-term bonds as 10-year Treasury yields rise above 2.75%.

To help minimize exposure to interest rate fluctuations, consider a barbell strategy that divides your bond allocation between short-term bonds that can be quickly reinvested when rates rise and longer-term bonds for their yields. A bond ladder, in which you purchase bonds that mature at staggered dates, can also make sense.

“With rates finally moving up, it’s likely to be a volatile few years,” Kathy says. “But with a broadly diversified portfolio of high-quality bonds or bond funds, you should be in a strong position to roll with the punches in 2022 and 2023.”