How to Build a Bond Portfolio

January 25, 2023 Collin Martin
From "how" to "why now," here are five key things investors should understand about bond investing.

Bonds are back! That's been our theme recently as we highlight the attractive yields that many bond investments offer.

But there may be some confusion regarding how to actually invest, given how large and complex the bond market is. It might seem tempting to wait for better opportunities to invest, as the Federal Reserve likely isn't done hiking rates and because many Treasury yields have actually fallen over the past few months.

Below we'll address five key points about bond investing, ranging from "how" to invest to "why now?"

1. Bonds for income and capital preservation

These are two of the key reasons to own high-quality bond investments. Most bonds make semiannual interest payments that are known in advance based on a percent of the par value. A missed interest payment generally triggers a default for the issuer, whereas stock dividend payments are discretionary and can be raised, lowered, or eliminated based on the outlook for the company. Defaults for highly rated investments tend to be rare, however; default risk is highest for investments with sub-investment-grade, or "junk," ratings.

Bonds also have fixed par values and maturity dates, so barring a default, investors know in advance what they'll receive and when.

Bond prices can still rise and fall in the secondary markets, which might catch investors off guard because bonds are often considered "safe" investments. Bonds have interest rate risk, so their prices can rise and fall with the changing interest rate environment, as the chart below illustrates.

Shown below is the price of a Treasury note that matured in May 2022. It was issued in May 2012 at its $1,000 par value—meaning it was a 10-year note when issued—and matured at its $1,000 par value. As you can see, it was a bumpy ride along the way, illustrating that even high-quality investments like U.S. Treasuries can experience ups and downs. Yet the Treasury note matured at its par value in May 2022, meaning the principal was preserved, while still paying 1.75% annually to bondholders. Holding bonds to maturity can help investors "look through" any potential price changes, as those price increases and decreases are ultimately unrealized. Keep in mind that this illustration is for one individual bond. Bond mutual funds and ETFs generally don't have set maturity dates or par values, so there are additional considerations for investors when deciding what approach is most appropriate.

Even high-quality bonds can see large price swings, but barring default should mature at their par value

Chart shows the secondary market price changes during a 10-year period for a U.S. Treasury note purchased in 2012 and maturing in 2022. Although the price fluctuated throughout the period, the bond ultimately matured at its par value and paid bondholders 1.75% annually.

Source: Bloomberg, using daily data as of 5/15/2022

U.S. Treasury Note, 1.75% coupon rate, 5/15/2022 maturity date (Cusip: 912828SV3 Govt). For illustrative purposes only. Past performance is no guarantee of future results.

2. Start with core bonds and add lower-rated investments, depending on your risk tolerance

The bond market is large and complex, with different types of bonds with varying degrees of risk. It can be difficult to know where to even start.

We suggest most investors first focus on "core" bonds, or high-quality bonds, like U.S. Treasuries, certificates of deposit, mortgage-backed securities, investment-grade corporate and municipal bonds, as well as Treasury Inflation-Protected Securities. These generally have low to moderate credit risk, depending on the investment, and tend to offer more diversification benefits when combined with stocks in a portfolio compared to bond investments with more risk. Think of core bonds as the "ballast" to your portfolio. We suggest they make up the bulk of your fixed income holdings.

Over the past 10 years, U.S. Treasuries have had a negative correlation with the S&P 500® index, while other high-quality investments like mortgage-backed securities, municipal bonds, and the Bloomberg U.S. Aggregate Bond Index have had relatively low correlations. Riskier investments at the bottom of the chart below have high correlations with U.S. stocks, so if the stock market is falling, it's likely that these investments are as well.

Fixed income investments: Correlations with the S&P 500

Chart shows the 10-year correlations of various fixed income investments with the S&P 500 index. U.S. Treasuries are the least correlated with the S&P 500, while high-yield corporate bonds are the most highly correlated with the S&P 500.

Source: Schwab Center for Financial Research with data from Bloomberg.

Indexes representing the investment types are: U.S. Treasuries = Bloomberg U.S. Treasury Index; Mortgage-Backed Securities = Bloomberg MBS Index; U.S. Aggregate Bond Index = Bloomberg U.S. Aggregate Bond Index; Municipal Bonds = U.S. Municipal Bond Index; Investment Grade Corporate Bonds = Bloomberg U.S. Corporate Bond Index; Preferred Securities = ICE BofA Fixed Rate Preferred Securities Index; Bank Loans = Morningstar LSTA Leveraged Loan 100 Index; High-Yield Corporate Bonds = Bloomberg U.S. Corporate High-Yield Bond Index.

Correlation is a statistical measure of how two investments have historically moved in relation to each other, and ranges from -1 to +1. A correlation of 1 indicates a perfect positive correlation, while a correlation of -1 indicates a perfect negative correlation. A correlation of zero means the assets are not correlated. Correlations shown represent an equal-weighted average of the correlations of each asset class with the S&P 500 during the 10-year period between January 2012 through December 2022. Diversification strategies do not ensure a profit and do not protect against losses in declining markets. Past performance is no guarantee of future results.

After building a base of core holdings, investors may consider adding "aggressive income" investments like those highlighted in the table below. These investments come with greater risks—like the risk of default—and any allocation should be in line with an investor's risk tolerance. These investments should always be considered as a complement to core bond holdings, not a substitute.

A framework for bond investing

Chart shows a suggested asset allocation to core bonds, international bonds and aggressive income bonds, along with their respective weightings in the U.S. Aggregate Bond Index.

Source: Schwab Center for Financial Research

* Suggested allocation range as a percent of the overall portfolio.
** Agency mortgage-backed securities includes Ginnie Mae, Fannie Mae, and Freddie Mac mortgage-backed securities.
*** We suggest the total of all aggressive income investments constitute no more than 20% of an investor’s overall portfolio unless the investor's objective is for high income with a high tolerance for risk.

For illustrative purposes only.

3. Higher yields come with higher risks

The higher yields that aggressive income investments offer may be tempting, but they come with more volatility and larger potential drawdowns. The chart below compares the average annualized total returns with the average annualized standard deviation (a measure of risk) between many fixed income asset classes. The Y axis represents the annualized total returns—the higher the dot, the higher the average return. But it also shows that higher returns tend to come with more risk, as the X axis illustrates. A higher standard deviation means more volatility, so investors reaching for higher-yielding investments need to be ready to ride out the ups and downs.

Riskier investments like high-yield bonds and preferred securities also tend to have higher correlations with stocks, so they don't provide many diversification benefits to an overall investment portfolio. A high correlation means that their total returns tend to move in the same direction as stock total returns. That can be a good thing when stock prices are rising, but when stocks are falling they tend to fall as well.

Higher yields come with higher risks

Scatter plot shows the relationship between various fixed income investments, their average annualized total return, and their average annualized standard deviation.

Source: Schwab Center for Financial Research with data from Bloomberg.

Average annualized total returns and standard deviations are for the 20-year period from January 2002 through December 2022. Standard deviation is a measure of how much an asset's return varies from its average return over time. Indexes represented are: High-yield corporates = Bloomberg U.S. Corporate High-Yield Bond Index; Preferred securities = ICE BofA Fixed Rate Preferred Securities Index; Investment-grade corporates = Bloomberg U.S. Corporate Bond Index; Municipal bonds = Bloomberg Municipal Bond Index; U.S. Aggregate = Bloomberg U.S. Aggregate Bond Index; Short-term Treasuries =  Bloomberg U.S. Treasury Short-term Index; Intermediate-term Treasuries = Bloomberg Treasury Intermediate-term Index; Long-term Treasuries = Bloomberg U.S. Treasury Long-term Index; Agency MBS = Bloomberg U.S. MBS Index; International bonds = Bloomberg Global Aggregate ex-USD Bond Index; and Emerging markets = Bloomberg Emerging Market USD Aggregate Index. Past performance is no guarantee of future results.

High-yield corporate bonds have low credit ratings and have higher default rates than those with investment-grade ratings, so when the economic outlook deteriorates, they tend to underperform. Corporate profits tend to suffer in a slowing economic environment, meaning it could be more difficult for low-rated corporations to remain current on their interest payments or even repay a maturing bond. Given those risks, we expect a bumpy ride for riskier investments this year.

4. No one rings a bell at the top

When yields hit their peak, they rarely stay there for a sustained period of time. Over the last 30 years, the 10-year Treasury yield tended to fall once it hit its peak, and that trend appears to be intact today. After touching 4.25% in October 2022, the 10-year Treasury yield has steadily declined over the past few months, dropping as low as 3.37% on January 18th. We believe that 4.25% yield was the cyclical peak and that yields should continue to decline as the year progresses. However, it's likely to be a bumpy road with bouts of volatility.

The 10-year Treasury yield rarely holds steady at its peak

Chart shows the movement of the 10-year U.S. Treasury yield going back to 1993.

Source: Bloomberg, using weekly data as of 1/20/2022.

US Generic Govt 10Yr (USGG10YR Index). Past performance is no guarantee of future results.

Despite the recent decline in yields, we continue to suggest investors gradually extend duration—meaning investing in bonds with more intermediate- or long-term maturities—rather than waiting in cash or other short-term investments for yields to rise more. Although the 10-year Treasury yield is below its recent peak, it's still at the high end of the post-financial-crisis trading range. Aside from the recent readings, the 10-year yield hadn't touched 3.5% since 2011.

Waiting for yields to rise is also an attempt to time the market, which is something we rarely suggest for long-term investors. Just as we wouldn't suggest a stock investor wait for the market to bottom—potentially missing out on gains if the bottom already happened—we don't suggest investors wait for the perfect time to invest. Yields for high-quality investments are at their highest levels in years, so we suggest investors take advantage by considering bonds today.

5. Why invest in intermediate- and long-term bonds if short-term yields are higher?

Despite the inverted yield curve, we think it makes sense to gradually extend the average duration of your bond holdings.

The chart below highlights this conundrum, with one- and two-year Treasuries offering yields of 4.6% and 4.1% respectively, while the 10-year Treasury note only offers a 3.4% yield. We still suggest intermediate- and long-term bonds to reduce the potential for reinvestment risk, which is the risk that short-term bonds could be reinvested at lower yields.

While the Fed is still hiking rates, the markets are already pricing in the potential for rate cuts later this year if growth and inflation fall too much. In that scenario, bonds that mature in the next few years could be reinvested at lower rates. So while accepting lower yields with longer maturities might be a tough pill to swallow, it helps reduce the risk of even lower yields down the road.

Not all yield curves are inverted, however. The corporate and municipal bond curves are more upward-sloping, so investors can still be rewarded with higher yields by considering longer-term bonds in those markets.

The 10-year Treasury yield curve is deeply inverted

Chart shows the 10-year Treasury yield curve as of January 19th, 2023. One and two-year securities are yielding more than 4%, while the 10-year yield is yielding less, at 3.4%. This is an example of an inverted yield curve.

Source: Bloomberg, as of 1/19/2023

What investors can consider now

The fixed income landscape is attractive today. After a disappointing 2022, the starting point for yields is significantly higher than it was last year, and with the Fed nearing the end of its rate hike cycle, high-quality bond prices are less at risk of sharp declines. We prefer high-quality fixed income investments, like the "core" bond segments mentioned above. With a gloomy economic outlook, we're cautious on the riskier parts of the market. There may be better entry points down the road to consider larger positions of lower-rated bonds, but until then a more cautious approach is warranted.

There are number of ways to invest in bonds: individual bonds, mutual funds, exchange-traded funds (ETFs), or separately managed accounts. There are benefits and drawbacks of each approach, and it ultimately comes down to investor preferences.

Schwab clients may search for individual bonds that meet their investment objectives and investing time horizon. For investors considering bond funds, the Mutual Fund Select List or ETF Select List are two good places to start. Separately managed accounts offer professional management, but investors actually own each individual bond.

Investors should consider carefully information contained in the prospectus or, if available, the summary prospectus, including investment objectives, risks, charges, and expenses. Please read it carefully before investing.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Investing involves risk including loss of principal.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. For more information on indexes please see schwab.com/indexdefinitions.

Diversification and asset allocation strategies do not ensure a profit and do not protect against losses in declining markets.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

Tax-exempt bonds are not necessarily suitable for all investors. Information related to a security's tax-exempt status (federal and in-state) is obtained from third parties, and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the alternative minimum tax. Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

Preferred securities are often callable, meaning the issuing company may redeem the security at a certain price after a certain date. Such call features may affect yield. Preferred securities generally have lower credit ratings and a lower claim to assets than the issuer's individual bonds. Like bonds, prices of preferred securities tend to move inversely with interest rates, so they are subject to increased loss of principal during periods of rising interest rates. Investment value will fluctuate, and preferred securities, when sold before maturity, may be worth more or less than original cost. Preferred securities are subject to various other risks including changes in interest rates and credit quality, default risks, market valuations, liquidity, prepayments, early redemption, deferral risk, corporate events, tax ramifications, and other factors.

Bank loans are typically below investment-grade credit quality and may be subject to more credit risk, including the risk of nonpayment of principal or interest. Most bank loans are floating rate, with interest rates that are tied to LIBOR or another short-term reference rate, so substantial increases in interest rates may make it more difficult for issuers to service their debt and cause an increase in loan defaults. Bank loans are typically secured by collateral posted by the issuer, or guarantees of its affiliates, the value of which may decline and be insufficient to cover repayment of the loan. Many loans are relatively illiquid or are subject to restrictions on resales, have delayed settlement periods, and may be difficult to value. Bank loans are also subject to maturity extension risk and prepayment risk.

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively "Bloomberg"). Bloomberg or Bloomberg's licensors own all proprietary rights in the Bloomberg Indices. Neither Bloomberg nor Bloomberg's licensors approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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