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—low interest rates tend to undercut their appeal, particularly where income is concerned.
Now, with higher interest rates, the yields bond investors so desperately craved are 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. "The recent cycle of interest rate hikes has allowed some investors to generate income without having to assume undue risk."
Although the Fed is expected to start cutting interest rates in 2024, Kathy believes its target for the year will remain near 4.50%. Even investors 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. "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 different types of core and noncore bonds, their risk profiles, and how higher rates might affect them.
Core bonds
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 higher interest rates.
Treasuries
What makes them unique: Issued by the federal government, U.S. Treasuries come in three varieties—Treasury bills, Treasury notes, and Treasury bonds—and are among the safest 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.)
The effect of higher interest rates: As the Fed raised interest rates, Treasury yields also rose. "This is something we waited for years to have happen," Kathy says. With yields poised to remain high for now, investors can still capture attractive yields in shorter-term Treasuries (bills and shorter-term notes). As rates level off or fall, investors can lock in higher yields on intermediate- and longer-term issues.
Munis
What makes them unique: Municipal bonds generally fall into one of two categories—general obligation (GO) bonds or revenue bonds. Interest earned on the majority of munis 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 higher interest rates: Investors have shown strong demand for all tax-efficient investments in recent years, driving up muni prices and pushing down their yields. "While rates remain high, investors may want to consider investing in slightly longer-term munis in order to capture the additional yield," Kathy says.
Price vs. yield
The simplest way to calculate a bond's yield is to divide its annual interest payouts by the price you paid for the bond and then multiply the result by 100. For example, let's say you paid $10,000 for a bond that pays you $500 in annual interest, resulting in a 5% annual yield:
$500 (total annual interest)/$10,000 (price paid for bond) = 0.05 x 100 = 5% (annual yield)
As interest rates rise, existing bonds lose some of their value because their yields become less attractive than those offered by new bonds. So, if you want to entice an investor into buying your existing bond, you would likely need to part with it for less than you paid.
If interest rates rise to 6%, for example, you'd need to sell your bond at a discount to make it attractive in that environment:
$500 (total annual interest)/$9,000 (new price paid of bond) = 0.055 x 100 = 5.5% (annual yield)
Investment-grade corporates
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 higher interest rates: When interest rates are high, companies 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 a high-interest-rate environment, Kathy suggests sticking to issuers with high credit ratings and opting for short-term bonds until rates level out and investors can lock in higher yields on longer-term issues.
Noncore bonds
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 government 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.
High-yield corporates
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 higher interest rates: With higher interest rates, high-yield issuers 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 elevated 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.
Emerging market and international government bonds
What makes them unique: Emerging-market and international government bonds are often structured similarly to Treasuries, but unlike U.S. debt—which is backed by the full faith and credit of the U.S. government—these bonds 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 higher interest rates: Many central banks in emerging markets started raising rates in the spring of 2021 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 government bonds may offer higher yields over U.S. bonds in the long run," Kathy says. Yields for international government 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.
Mortgage-backed securities
What makes them unique: Unlike most bonds, mortgage-backed securities—those secured by home and other real estate loans—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 higher 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 higher-rate environment.
Treasury Inflation-Protected Securities (TIPS)
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 higher interest rates: TIPS were 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 until rates drop significantly. "In this environment of higher rates, a strong dollar, and liquidity concerns, it's probably wise to limit your exposure to these particular securities."
Stay diversified
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—near an intermediate-term benchmark. Buy-and-hold investors may want to spread out the maturities of their bonds to achieve an average that matches up with their financial needs.
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. Your investment goals and time frame will help determine the best bond strategy for your situation.
"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 2024."
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